What is a cost of goods sold?

In plain English

For a product business, COGS is beginning inventory plus purchases minus ending inventory. It is subtracted from revenue to get gross profit.

Service businesses may track direct labor and materials as cost of sales.

Why it matters

Cost of goods sold separates the cost of making or buying what you sell from the cost of running the business. Without it, you cannot see your gross profit, which is the clearest signal of whether your pricing covers your direct costs.

Getting it wrong distorts more than one report. If inventory purchases are expensed as they are bought instead of when items are sold, a month of heavy restocking looks like a loss and a month of selling from stock looks like a windfall. That can lead to bad pricing and purchasing decisions.

Worked example

$8,000 + $14,500 - $9,300 = $13,200 COGS. With $31,000 of sales, gross profit is $17,800.

How to handle it

1. Decide with your accountant which costs count as direct costs for your business.
2. Create cost of goods sold accounts for those costs, separate from operating expenses.
3. If you hold inventory, record purchases to inventory and move the cost of items sold to cost of goods sold.
4. Count inventory at least at year end and adjust the books to match the count.
5. Review gross profit each month and look into any sudden change.

Common mistakes

• Putting rent, office supplies or marketing into cost of goods sold, which understates gross profit and hides the real product margin.
• Expensing all inventory purchases when bought, which ties monthly profit to purchasing timing instead of sales.
• Skipping inventory counts, so theft, damage and errors build up until a large surprise adjustment at year end.
• Leaving freight in costs out of product cost, which makes items look cheaper than they are.

Not the same as: Operating expenses

Cost of goods sold covers direct costs of what you sold. Operating expenses are overhead such as rent, admin salaries and software, which you pay whether or not you make a sale. See Operating expenses.

Go deeper

• Cost of Goods Sold Explained for Small Business: What cost of goods sold includes, how to calculate it for products and services, and why getting it right matters for margins and taxes.
• Inventory Costing: FIFO, LIFO and Average Cost: Compare FIFO, LIFO and weighted average inventory costing with a simple example, and learn how the method changes profit and taxes.

Try it

Use the related free tool.

Related terms

• Credit memo: A document that reduces the amount a customer owes, usually for a return, error or discount.
• Current assets: Assets expected to be turned into cash or used up within about a year.
• Clearing account: A temporary account that holds money or entries until they are matched to the final destination.

Common questions

General information, not tax, legal or accounting advice. Confirm rules with the IRS, the NJ Division of Taxation or a licensed professional.