Cost of goods sold (COGS), explained

Cost of goods sold is one of the most important lines on the profit-and-loss, and one of the most commonly miscategorised. Get it right and your gross margin tells the truth about your product; get it wrong and every margin figure lies. Here’s what COGS actually is.

What COGS is

Cost of goods sold is the direct cost of the products or services you actually sold in a period. For a product business it’s the cost of the inventory that went out the door; for a service business it’s the direct cost of delivering the service. The key word is direct — costs tied specifically to producing what you sold.

What’s in it — and what isn’t

Usually in COGS: the cost of materials and inventory sold, and direct labour that produces the product or service.

Usually not in COGS: general overheads — rent, admin salaries, marketing, office costs. These are operating expenses, below the gross-profit line. The classic error is dumping overhead into COGS (or vice versa), which distorts gross margin and makes the product look more or less profitable than it is.

Why it drives gross profit

Gross profit is simply revenue minus COGS. It’s the money left from a sale after paying for the thing you sold, before overheads. Gross margin (gross profit as a percentage of revenue) is one of the truest measures of whether a product makes money — and it’s only as accurate as your COGS.

The inventory connection

For a product business, COGS and inventory are two sides of one coin: as inventory is sold, its cost moves from the balance sheet (inventory asset) to the P&L (COGS). This is exactly why wrong inventory data throws COGS off — if opening inventory or its valuation is wrong, the cost flowing to COGS is wrong, and gross margin with it.