COGS: What It Means for Small Businesses

What is COGS?

COGS, short for Cost of Goods Sold, is a financial metric that tells you how much it cost to produce or purchase the goods that a business sold during a specific period. For retailers, COGS typically includes the purchase price of merchandise and any inbound shipping or handling costs. For manufacturers, it includes direct materials, direct labor, and an allocated portion of manufacturing overhead associated with goods that were sold.

Why COGS matters — in plain terms

Think of your business as a lemonade stand. If you sell 10 cups of lemonade, the money you spent on lemons, sugar, and cups for those 10 cups is your COGS. COGS matters because it directly affects gross profit: Revenue minus COGS equals gross profit. Keeping COGS under control helps ensure you actually make money on each sale.

Main components of COGS (beginner-friendly breakdown)

• Purchases: For retailers, the amount you paid to buy the products you resold.
• Direct materials: Raw materials used to make products (applies to manufacturers).
• Direct labor: Wages for employees who directly produce the goods.
• Manufacturing overhead: A portion of factory rent, utilities, and equipment depreciation linked to production.
• Freight-in: Shipping costs to bring inventory to your location (when charged to inventory).

Simple formula

The basic formula many beginners use is:

COGS = Beginning Inventory + Purchases (or Production) - Ending Inventory

This formula works for a defined accounting period (monthly, quarterly, annually). Beginning Inventory is what you started with; Purchases or Production adds what you acquired or made; Ending Inventory is what you still have unsold.

Inventory valuation methods

How you count and value your ending inventory affects COGS. The common methods are:

• FIFO (First In, First Out): Assumes oldest inventory is sold first. Often matches physical flow for perishable items.
• LIFO (Last In, First Out): Assumes newest inventory is sold first. Less common outside the U.S. due to tax and accounting rules.
• Weighted average: Spreads the cost evenly across units

Beginner example (retailer)

Imagine you start the month with 100 widgets in inventory valued at $5 each (Beginning Inventory = $500). You buy 200 widgets during the month at $6 each (Purchases = $1,200). At month end you have 120 widgets left (Ending Inventory = 120 units). If using simple unit-cost tracking and assuming the average cost is used, your COGS for the month equals Beginning Inventory + Purchases - Ending Inventory value. That difference represents the cost of the units you sold.

How COGS differs from operating expenses

COGS are direct costs tied to making or buying goods that were sold. Operating expenses (rent, marketing, administrative salaries) are not included in COGS. This separation is important because it clarifies gross profit (revenue minus COGS) versus operating profit (gross profit minus operating expenses).

Real-world relevance

For a small e-commerce seller, tracking COGS helps you determine accurate gross margins and set profitable prices. For example, if your product sells for $30 and your COGS is $18, your gross profit per sale is $12. Ignoring COGS might make your business look profitable on paper while you lose money in reality.

Common beginner mistakes

• Mixing operating expenses with COGS (e.g., including marketing in COGS).
• Forgetting to account for freight-in or import duties when they belong in inventory cost.
• Inconsistent inventory valuation methods across periods, which makes comparisons unreliable.

Practical tips

Keep clear records of purchases and inventory movements, choose an inventory valuation method and stick with it, and consider simple accounting software that automatically tracks COGS. If you sell physical goods, knowing your COGS is one of the fastest ways to assess your business health.

In short, COGS tells you how much it cost to produce what you sold. For beginners, mastering COGS is an essential step toward pricing products correctly, managing inventory, and improving profitability.