How to calculate cost of goods sold (COGS) for your business

As you figure out the sweet spot for pricing your product or service, you’ll want to understand how much you’re spending to produce it. That’s where the all-important cost of goods sold (COGS) metric comes in handy—defining the direct costs of making the goods your business sells (but different from your operating expenses). Whether you’re managing inventory daily or checking in every once in a while, understanding COGS helps you price your products correctly, manage cash flow and boost profitability.

Explore more about COGS, how to calculate it and why it matters to your business’s bottom line.

What you’ll learn:

• Calculating COGS is key to understanding how much money your business is actually making.

• To calculate COGS, you need to know your beginning inventory, purchases and ending inventory costs.

• Accurate COGS calculations help control costs and improve profitability.

• COGS works alongside other financial metrics to give you a full view of your business’s financial health.

COGS is the direct costs involved in producing the goods your business sells. These expenses include raw materials, labor and manufacturing costs—anything directly tied to creating your product.

COGS is a helpful metric for financial reporting because it helps you determine your gross profit, showing how much money you’re making after factoring in production costs. This information is key for setting prices, managing costs and cash flow and giving you a clear look at how well your business is running.

When calculating COGS, you can include all the direct costs that go into making your product.

These typically cover:

• Raw materials: The basic ingredients or components needed to create your product

• Direct labor: The wages of employees—like factory workers or assembly line staff—directly involved in production

• Manufacturing supplies: Items like tools, machinery or equipment used in the production process

• Freight and shipping costs: The fees required to bring any materials in

What doesn’t count? Indirect costs like rent, utilities or marketing expenses. These are considered operating expenses and aren’t part of COGS. By focusing only on the direct costs, you get a precise picture of what it truly costs to create your product.

Calculating COGS is pretty straightforward once you know what to include. The basic formula is:

COGS = Beginning Inventory + Purchases − Ending Inventory

When you calculate COGS, you’re figuring out the cost of what you actually sold during a certain period. You add your starting inventory to any new purchases, then subtract whatever inventory you still have at the end.

Think of it like this:

• Beginning inventory: The value of your products when the period began (like the beginning of the month or year)

• Purchases: The cost of new products or materials you bought during that period

• Ending inventory: The value of the inventory you still have left at the end of the period

Let’s look at two examples—one for a retail business and another for a manufacturing business—to see how COGS works in different situations.

Suppose you own a clothing business. At the start of the month, your inventory is valued at $5,000. During the month, you buy an additional $3,000 worth of new stock. By the end of the month, you have $4,000 worth of inventory left.

• Beginning inventory: $5,000

• Purchases: $3,000

• Ending inventory: $4,000

Now use the formula:

COGS = $5,000 + $3,000 − $4,000 = $4,000

So your COGS for the month is $4,000. That means you spent $4,000 on the products sold during the month.

Now, let’s say you run a small manufacturing company that builds custom furniture. You start the month with $8,000 worth of raw materials. During the month, you buy another $6,000 in materials, and by the end of the month, you’ve got $5,000 worth of raw materials left.

• Beginning inventory: $8,000
• Purchases: $6,000
• Ending inventory: $5,000

So to calculate COGS, you simply do this:

COGS = $8,000 + $6,000 − $5,000 = $9,000

In this case, your COGS is $9,000. That’s the cost of the materials used to make the furniture you sold during the month.

Understanding COGS is key when setting your product prices. Why? Because your COGS directly affects your gross profit—the money you have left from your earnings after covering the costs of producing and selling your goods. If your COGS is too high, your profit margins will shrink—even if you’re making a lot of sales.

Once you’ve got a clear handle on your COGS, you can establish prices that allow you to collect a solid profit that goes beyond simply covering your costs. It helps you spot when production costs increase, so you can adjust your prices if needed. Plus, it shows where you might be able to cut costs—whether by negotiating better rates with suppliers or streamlining your operations.

The better you understand the true cost of making and selling your products, the easier it is to set prices that keep your business both competitive and profitable.

COGS is just one piece of the puzzle for understanding your business’s financial health. To get the full picture, keep track of expenses and compare COGS with other common metrics like operating expenses, cost of sales and overhead. Each one tells a different story about where your money is going and how your business is running.

Operating expenses are the costs you incur to run your business day to day. However, these costs are not directly tied to making your products. Some examples of operating expenses are:

• Rent

• Utilities

• Marketing

• Salaries (not directly related to production of goods)

• Office supplies

While COGS covers the costs of making or obtaining your products, operating expenses are what it takes to keep the business running smoothly. Both metrics impact your profitability, but they show up in different places on your income statement.

Cost of sales is sometimes used interchangeably with COGS, but there’s a small difference. Cost of sales is a broad term that generally applies to businesses that sell both goods and services.

For a product-based business, cost of sales and COGS might be the same. But if you’re offering services, cost of sales could include labor or materials used to deliver the service—even though there’s no physical inventory involved.

Another key difference is where they’re located on your income statement. COGS appears right after your business’s revenue, while cost of sales shows up just before your operating margin. This helps you see how much it costs to generate revenue from both products and services before factoring in your daily operating expenses.

Overhead refers to your ongoing business costs not directly connected to product creation or delivering a service. It’s similar to operating expenses, but typically focuses more on fixed costs such as rent, insurance and utilities.

Overhead expenses keep your business running, no matter how much you produce or sell. While COGS changes with how much you make, overhead tends to stay relatively steady.

On your income statement, overhead may be part of your operating expenses—showing up after COGS and cost of sales. In other words, overhead is factored in after you’ve calculated the direct costs of making your products or delivering services but before you get to your operating income. Keeping track of overhead is key to understanding the full cost of running your business.

Knowing your cost of goods sold is more than just a bookkeeping task—it’s a key part of understanding how your business truly makes money. COGS tells you how much it costs to produce the goods you sell. This affects everything from pricing to your profits to your cash flow. When you calculate COGS accurately, you get a clearer picture of your gross profit. This enables you to make more-informed decisions on behalf of your business. And when you understand how COGS fits alongside other financial metrics, you have a clearer view of your business’s overall financial health.

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