Cost of Goods Sold (COGS): Definition, Formulas and Examples

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Cost of goods sold (COGS) represents all the direct expenses it takes a business to produce the goods it’s selling during a specific period of time. That could include things like materials, supplies, or direct labor.

When you’re putting together an income statement for your business, one of the most important steps is accurately figuring your cost of goods sold (COGS), because it’s the portion of your expenses you have the most immediate control over.

Subtracting COGS from total income tells you your gross profit, which can help you decide which parts of your business (e.g., enterprises or projects) to expand or scale back, which production methods to use, and even how to get your product to market. Let’s go through how it works and what you need to know.

Key takeaways

• Cost of goods sold (COGS) includes all the direct expenses that went into producing (or in some cases, buying) the goods a business sold during a period of time.

• To get your gross profit, subtract COGS from your revenue.

• Overhead costs like rent, advertising, or accounting software are generally counted as operating expenses, not COGS.

• Some costs can land in either bucket (COGS or operating), depending on your business. For example, fuel could be a direct cost for a trucking company but an operating expense for a farm store.

• Your inventory costing method, such as FIFO or weighted average, will decide which purchase costs reach COGS first.

What is cost of goods sold (COGS)?

Your cost of goods sold (COGS) includes any expenses your business made that went directly into producing (or buying) the goods you sold.

On an income or profit and loss statement, COGS is often listed right after income, before any other expenses. Those other expenses are often less directly tied to production—e.g. utilities, marketing and administrative costs—and are referred to as “operating expenses.”

COGS: Examples

• Grain, seed and straw

• Salt, minerals and protein

• Building materials

• Forages and pasture rental

• Herd replacement

• Veterinary medicine and supplies

• Death loss

• Breeding costs and bull leasing

• Fertilizer

• Production labor

• Subcontractors

• Manure removal

• Trays, boxes, bags and labels

Operating Expenses: Examples

• Marketing costs

• Fuel and utilities

• Hauling

• Transportation

• Maintenance and repairs

• Software subscriptions

• Office expenses

• Retailer fees

• Distributor fees

• Insurance

• Commissions

If you’re ever wondering whether an expense qualifies as a COGS, consider whether it’s directly related to producing goods, and whether decreasing or increasing production would decrease or increase that cost.

If you raise more beef, for example, you’ll need to increase the amount of feed you use, making that a COGS expense.

COGS vs. operating expenses

COGS and operating expenses both contribute to your overall cost of doing business, but they sit in different places on your income statement and answer different questions about your operation.

If you’re not sure whether an expense counts as COGS or overhead, it’s a good idea to check in with your accountant and ask what they recommend. Together, you can build a chart of accounts with expense categories that make sense for your specific business.

How do I calculate COGS?

Accounting software like Ambrook can help you calculate COGS automatically, but if you’re starting from scratch using pen and paper or a spreadsheet-based income statement, you’ll have to calculate COGS manually.

To calculate total COGS for your entire operation, you’ll need to add up all of your variable or “direct” costs, which are costs that increase with each additional unit of output.

For cow-calf operations, for example, this might include feed (pasture, hay or rations), supplements, labor, and breeding costs, while for feedstock production it might include seed and fertilizer, fuel, and labor. For a general contractor, that could look more like adding up the materials, subcontractors, and rented equipment you got for a particular job.

Inventory costs are a big part of COGS, and how you account for them matters. For example, choosing a costing method like FIFO or WAC can affect which inventory gets “used up” and recognized as COGS first.

For consistency, you’ll also need to decide whether to include costs like family labor and your own unpaid labor in COGS, or whether you’ll include only cash costs.

Cost of goods sold formula

If we express the above as a formula, we get:

COGS = Raw materials used + Direct labor costs + Any other variable costs used in production

This is how most small businesses calculate COGS, if they don’t track inventory. But you might also see COGS defined using the following formula:

COGS = (Beginning inventory + Purchases) – Ending inventory

This formula reflects how inventory under an accrual accounting system works, and ensures that COGS reflects what actually got sold, not just what was produced. If you track inventory in software like Ambrook, the system can typically calculate COGS for you as items are sold or used, following the FIFO or weighted average method you pick for each item.

COGS example

Let’s go through a simplified example: Say you have a farm store. You start the year with $18,000 of inventory, then buy $62,000 more during the year. On December 31, you’ve got $15,000 on the shelves and you know you brought in $100,000 in sales during the year.

This means your store kept 35 cents on every dollar you made, before factoring in the overhead costs it took to run the operation overall.

Why is COGS important?

1. Profitability insight

Subtracting COGS from revenue gets you gross profit, which can help you with enterprise analysis: understanding whether a certain business line, or enterprise, in your operation is profitable. If your COGS are creeping up, margins can shrink, and changes might be in order.

2. Pricing and strategic decisions

Knowing your true cost of producing a calf, backgrounding a feeder, completing a job, hauling a load, or harvesting a ton of hay helps you make better pricing decisions and target a specific level of return on your spending.

3. Cost control and benchmarking

Having a consistent COGS methodology allows you to compare your numbers year to year or against industry benchmarks, which can surface important trends.

4. Investment and expansion decisions

If you know your cost structure, you can better assess the impact of adding a new enterprise to your business.

5. Tax and accounting clarity

Under accrual accounting, COGS affects your taxable income and proper matching of revenue and expenses.

How does COGS work for a cash basis business?

Accrual accounting matches costs like COGS to the revenue they help generate, which prevents margins from being distorted by timing differences between when expenses are paid and when income is earned.

Many U.S. farmers and other small businesses operate on a cash-basis accounting system, however, which means only expenses actually paid in cash during the year are counted. If you don’t track inventory, COGS essentially becomes a subtotal of the direct costs purchased specifically for customer work. Whether the expense was paid by invoice, check, or credit card, the deductible amount for taxes is simply what was paid in cash during the year.

For tax returns, start with the totals from your income statement, assuming it is prepared correctly. From there, apply any required adjustments to arrive at the final tax-deductible amounts, which are often slightly lower than the book totals.

Frequently asked questions (FAQs) about COGS

Let’s review the common questions and facts we’ve covered about COGS.

Is COGS an expense?

Yes. COGS is an expense on your income statement, typically listed right after revenue. It’s kept separate from operating expenses so you can see gross profit: what you earn on the goods themselves before factoring in your overhead.

What’s the difference between COGS and operating expenses?

COGS covers the direct costs of the goods you sold, like materials and direct labor. It typically rises and falls with output: If you produce more, your COGS will increase. Operating expenses, on the other hand, cover the costs of running your overall business. That could include rent, advertising, or accounting software, for example, which usually stay the same each month whether you sell more or less product.

Is labor included in COGS?

Only labor that goes directly into making the product or doing the job, like subcontractors you bring on for a specific build. If you have an office manager, for example, their wages would count as an operating expense.

How does inventory affect COGS?

If there are goods you’ve bought or raised but haven’t yet sold, they’ll sit in your inventory and represent part of your current assets. When you sell or use them, the cost of those goods becomes part of your COGS.

Is COGS a debit or a credit?

COGS is an expense account, so it increases with a debit. For more information, see our guides to debits and credits and journal entries.

Know your numbers with Ambrook

Ambrook brings bookkeeping, payments, and business insights into one place for operators. With custom categories, enterprises, and jobs, it’s easy to see gross profit for every part of your business. Plus, you can use Ambrook Inventory to calculate COGS as you sell inventory items.

This resource is provided for general informational purposes only. It does not constitute professional tax, legal, or accounting advice. The information may not apply to your specific situation. Please consult with a qualified tax professional regarding your individual circumstances before making any tax-related decisions.