If you run a business that sells products, you’ve probably heard the term “cost of goods sold” — but knowing exactly what goes into it (and what doesn’t) can make the difference between paying too much in taxes and pricing your products right. COGS represents the direct costs tied to producing the goods you sell, and its accurate calculation is critical for both your income statement and your tax return.

4 related posts

COGS definition: Direct costs to produce goods sold by a company ·
Includes: Raw materials, direct labor, manufacturing overhead ·
Excludes: Indirect expenses, sales & marketing, administration ·
Formula: Beginning inventory + purchases – ending inventory ·
Impact on tax: COGS deducted from revenue, reducing taxable income

Quick Snapshot

1What COGS Includes
2What COGS Excludes
3COGS vs Operating Expenses
4Key COGS Facts

Four accounting fundamentals define how COGS works in practice.

Label Value
COGS stands for Cost of Goods Sold
Accounting standard GAAP / IFRS
Income statement location Below revenue, above gross profit
Formula Beginning Inventory + Purchases – Ending Inventory

What Is Cost of Goods Sold?

How COGS differs from operating expenses

  • COGS: Direct costs tied to producing goods sold. Includes raw materials, direct labor, production overhead. (Investopedia (finance education platform))
  • Operating expenses: Period costs like marketing, rent, admin salaries. Not tied to production volume. (QuickBooks (accounting software provider))
  • COGS affects gross profit; operating expenses affect operating profit. (BILL (financial operations platform))

Key components: materials, labor, overhead

  • Raw materials: Components that become part of the finished product. (QuickBooks (accounting software provider))
  • Direct labor: Wages for workers directly involved in manufacturing. (Square (payment and business platform))
  • Manufacturing overhead: Factory utilities, rent, equipment depreciation allocated to production. (Investopedia (finance education platform))
Bottom line: COGS captures only the costs that directly vanish when you sell a unit. Marketing, sales, and admin costs stay out. For a small business, miscategorizing an expense into COGS can inflate gross profit or depress taxable income — the IRS draws a firm line.
The upshot

A retailer buying finished goods for $50 each and selling them will only include the $50 purchase cost in COGS. The store’s rent and employee salaries remain operating expenses, even if the store wouldn’t exist without sales.

How Do You Calculate Cost of Goods Sold?

The COGS formula: beginning inventory + purchases – ending inventory

The standard calculation works for any period — week, month, quarter, or year. Balboa Capital (equipment finance provider) confirms the formula is consistent across time frames.

  • Beginning inventory: Value of inventory at start of period. (Square (payment and business platform))
  • + Purchases: Cost of additional inventory bought during period. (QuickBooks (accounting software provider))
  • – Ending inventory: Value of unsold inventory at period end. (BILL (financial operations platform))
  • = COGS: Direct cost of goods actually sold. (Investopedia (finance education platform))

Step-by-step calculation example

  1. Determine beginning inventory – e.g., $10,000. (BILL (financial operations platform))
  2. Add purchases made during the period – e.g., $50,000. (BILL (financial operations platform))
  3. Subtract ending inventory – e.g., $15,000. (BILL (financial operations platform))
  4. Result: COGS = $45,000. Gross profit = Revenue – $45,000. (BILL (financial operations platform))

Another example from Square (payment and business platform): beginning inventory $5,000 + purchases $3,000 – ending inventory $2,000 = COGS of $6,000. The formula is the same regardless of business size.

Common mistake

If you forget to count inventory at year-end, your COGS will be wrong — overstating purchases or missing unsold stock. QuickBooks (accounting software provider) emphasizes that accurate tracking is essential for both profit measurement and tax reporting.

What Are Common COGS Examples?

Manufacturing company example

  • Raw materials: Steel, wood, electronics components. (QuickBooks (accounting software provider))
  • Direct labor: Assembly line workers’ wages. (Square (payment and business platform))
  • Factory overhead: Electricity for machinery, factory rent. (Investopedia (finance education platform))

Retail business example

  • Wholesale purchase cost of items bought for resale. (Investopedia (finance education platform))
  • Packaging required to make product ready for sale. Square (payment and business platform) notes that packaging costs count when the product can’t be sold without it.
  • Freight-in: Shipping costs to get inventory to your store. (FreeTaxUSA (tax preparation community))

Service business COGS differences

  • Pure service firms (consulting, law) typically have minimal or zero COGS because they don’t sell physical goods. (Investopedia (finance education platform))
  • If a service includes materials (e.g., plumber using parts), those materials go into COGS. (QuickBooks (accounting software provider))

The pattern: A manufacturer has the highest COGS ratio, a retailer sits in the middle, and a service business often reports zero COGS. Each must classify costs correctly to avoid misstating gross profit.

What Is COGS in Accounting?

How COGS is recorded on the income statement

BILL (financial operations platform) explains that COGS appears as the second line on an income statement, directly below revenue. Subtracting COGS from revenue yields gross profit. Operating expenses are then subtracted to get operating profit.

The income statement flow reveals how COGS separates production costs from other business expenses.

Income statement line Example
Revenue $100,000
Cost of Goods Sold ($45,000)
Gross Profit $55,000
Operating Expenses ($30,000)
Operating Profit $25,000

The catch: Every dollar miscategorized between COGS and operating expenses shifts gross profit and operating profit in opposite directions, distorting the financial picture lenders and investors see.

COGS and inventory valuation methods (FIFO, LIFO, average cost)

  • FIFO (First In, First Out): Assumes oldest inventory sold first. Higher COGS when prices rise. (Investopedia (finance education platform))
  • LIFO (Last In, First Out): Assumes newest inventory sold first. Lower COGS when prices rise. Used mainly for U.S. tax purposes. (Investopedia (finance education platform))
  • Average cost: Weighted average of all units. Smooths COGS. (Investopedia (finance education platform))

The catch: Inventory method directly affects COGS and taxable profit. A business that switches from FIFO to LIFO during inflation can report higher COGS, lower profit, and lower taxes — but must follow IRS rules.

How Do I Calculate My COGS for Small Business Taxes?

Using COGS to reduce taxable income

  • COGS is deducted from revenue before calculating taxable income. QuickBooks (accounting software provider) states it is a tax-deductible expense that lowers what you owe.
  • Balboa Capital (equipment finance provider) confirms that COGS is required on tax returns for businesses with inventory.
  • On Schedule C (U.S. sole proprietors), beginning inventory is reported as $0 if inventory isn’t being tracked, and only the cost of goods sold during the year is reported as purchases. (FreeTaxUSA (tax preparation community))

Common errors when calculating COGS for tax

  • Forgetting to count ending inventory — overstates COGS and understates profit.
  • Mixing direct and indirect costs — e.g., including office supplies in COGS.
  • Using the wrong inventory valuation method — IRS may require consistency or pre-approval for LIFO. (Investopedia (finance education platform))
What to watch

FreeTaxUSA gives a concrete retail example: buy 500 dresses at $50 each, sell 100 dresses → COGS = 100 × $50 = $5,000. The unsold 400 dresses remain in ending inventory and are not expensed until future sales. The implication: every miscounted dress shifts your tax liability in the current year.

What’s Confirmed and What’s Unclear About COGS?

Confirmed facts

  • COGS includes only direct production costs. (Investopedia (finance education platform))
  • COGS formula (Beginning Inventory + Purchases – Ending Inventory) is universally recognized in accounting. (Square (payment and business platform))
  • COGS is reported on the income statement and reduces taxable income. (QuickBooks (accounting software provider))

What’s unclear

  • Whether certain overhead items (e.g., a portion of rent) should be allocated to COGS or operating expenses can vary by industry and accounting policy. (QuickBooks (accounting software provider))
  • The exact percentage of COGS relative to revenue depends heavily on business model and industry — a manufacturer’s COGS may be 70% of revenue, while a retailer may be 50% and a service firm 0%. (Investopedia (finance education platform))
  • Whether shipping costs belong in COGS or as a selling expense depends on whether the shipping is needed to make the product ready for sale or a separate delivery charge. (FreeTaxUSA (tax preparation community))

Perspectives from Accounting Experts

Cost of goods sold (COGS) includes the direct costs of producing the goods sold by a company. This amount includes the cost of the materials and labor directly used to create the good.

Investopedia (finance education platform)

Cost of goods sold is the carrying value of goods sold during a particular period. Costs are associated with particular goods using one of several formulas, including specific identification, first-in first-out (FIFO), or average cost.

Wikipedia (community-maintained encyclopedia)

COGS is the direct cost to produce or purchase the goods you sell. It’s one of the most important numbers on your income statement because it directly affects your gross profit and net income.

Xero (small business accounting software)

Final Takeaway

Cost of goods sold is more than a line on the income statement — it’s the bridge between pricing strategy and tax compliance. Getting COGS right means knowing your inventory, classifying costs correctly, and choosing the right valuation method. For a small business owner, the decision is clear: invest in accurate inventory tracking and reconcile COGS quarterly, or risk overpaying taxes and mispricing products.

Related reading: **DOL Industry-Driven Skills Training Fund Grants Guide 2025** · **Social Security Phone Number: Official Numbers, Hours, and Tips**

Additional sources

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For a practical walkthrough of the cost of goods sold calculation, refer to our detailed COGS guide which offers additional examples and context.

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Frequently Asked Questions

Is COGS an asset or expense?

COGS is an expense, not an asset. It represents the cost of inventory that has been sold and is deducted from revenue on the income statement. Unsold inventory remains an asset on the balance sheet.

Does COGS include shipping costs?

Shipping costs can be included in COGS if they are required to make the product ready for sale (e.g., freight-in). Shipping costs to deliver finished goods to customers are typically operating expenses. Check IRS guidance for your specific situation.

Can COGS be negative?

No, COGS cannot be negative in normal accounting. A negative COGS would imply you sold more inventory than you had, which indicates an error in inventory tracking or a correction of a prior period mistake.

How do inventory valuation methods affect COGS?

FIFO, LIFO, and average cost each produce different COGS values when prices change. In rising-price environments, FIFO yields lower COGS and higher profit; LIFO yields higher COGS and lower profit. The method you choose must be consistent and disclosed in financial statements.

Is COGS the same as cost of sales?

Yes, in most contexts “cost of goods sold” and “cost of sales” are used interchangeably. Some service businesses prefer “cost of sales” when they include both products and services, but the accounting treatment is identical.

Do service businesses have COGS?

Pure service businesses (e.g., consultants, lawyers) typically have no COGS because they do not sell tangible products. However, if a service includes materials or labor for a product (e.g., a plumber using parts), those costs are included in COGS.

What happens if I overstate COGS?

Overstating COGS reduces taxable income, which may trigger an IRS audit. It also understates gross profit, making your business appear less profitable than it is — this can hurt loan applications and investor confidence.

How often should I calculate COGS?

Most businesses calculate COGS monthly or quarterly for internal reporting, and annually for tax returns. Accurate inventory counts at each period end are essential for correct COGS calculation.