COGS

COGS Definition

COGS (Cost of Goods Sold) represents the direct costs of producing the goods or services your business sells. For retailers, it's what you paid for the inventory you sold. For manufacturers, it includes materials, labor, and production overhead. For service businesses, it's the direct costs of delivering services. COGS appears on your P&L and directly reduces gross profit.

COGS in Practice — Example

You run a small bakery. In March, you sold $10,000 worth of bread, pastries, and cakes. Your COGS includes: $2,000 in flour, sugar, and ingredients, $1,500 in packaging, $800 in direct labor (bakers' wages), and $200 in utilities for the ovens. Total COGS: $4,500. Your gross profit is $10,000 - $4,500 = $5,500. Rent, marketing, and administrative costs aren't part of COGS — they're operating expenses that come after gross profit.

Why COGS Matters for Your Books

COGS is essential for calculating gross margin — the percentage of revenue left after direct costs. This metric reveals whether your pricing covers production costs before considering overhead. A declining gross margin often signals rising material costs or pricing pressure.

COGS also affects inventory valuation for businesses that carry stock. When you buy inventory, it's an asset. When you sell it, it becomes COGS (an expense). Proper COGS tracking ensures your inventory balance reflects what you actually have on hand.

For tax purposes, COGS directly reduces taxable income. Accurate COGS tracking maximizes legitimate deductions. However, the IRS has strict rules about what qualifies — direct costs only, not general overhead or administrative expenses.

How COGS Shows Up in QuickBooks

In QBO, set up COGS accounts under Cost of Goods Sold in your Chart of Accounts. When you sell inventory items, QBO automatically calculates COGS based on the item's cost. For service businesses, record direct costs (subcontractor fees, materials) as COGS. COGS appears on the Profit and Loss report between Revenue and Gross Profit. Track gross margin by dividing Gross Profit by Revenue.

Common Mistakes

Including overhead in COGS. Rent, insurance, office salaries, and marketing are operating expenses, not COGS. Only direct production costs belong in COGS.

Not tracking inventory properly. If you don't update item costs or track inventory quantities accurately, your COGS will be wrong — and so will your gross margin.

Forgetting labor costs. For businesses with production employees, their wages are part of COGS. Administrative and sales staff wages are operating expenses.

FAQ

Q: What's the difference between COGS and operating expenses? A: COGS are direct costs of production (materials, direct labor, production overhead). Operating expenses are indirect costs of running the business (rent, marketing, admin salaries). COGS reduces gross profit; operating expenses reduce net profit.

Q: Do service businesses have COGS? A: Yes, if there are direct costs to deliver services — subcontractor fees, materials, direct labor. A law firm's COGS might include court filing fees and expert witness costs. A consultant's COGS might include travel expenses for client projects.

Related Terms

Direct Cost

Break-Even

Contribution Margin

Chart of Accounts

Billable Expense

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