Guide
How to Calculate Cost of Goods Sold (COGS)
COGS = Beginning Inventory + Purchases − Ending Inventory. For manufacturers and service businesses: COGS = Materials + Direct Labor + Manufacturing Overhead. COGS includes only direct production costs — not rent, marketing, or admin salaries.
Cost of Goods Sold (COGS) tells you exactly what it costs to produce what you sell — and it's the foundation for calculating gross profit, setting prices, and understanding your margins.
The COGS Formula
COGS = Materials + Direct Labor + Manufacturing Overhead
For most small businesses, COGS has three components. Add up all three, and you have your total direct production cost for the period.
1. Materials (Raw Materials & Supplies)
Everything that goes into making your product. For a bakery, that's flour, sugar, eggs, and packaging. For a contractor, it's lumber, nails, and fixtures. For a service business, it's the consumables used in delivering the service.
2. Direct Labor
Wages paid to workers who physically produce your products or deliver your services. This includes hourly production workers, but not administrative or sales staff. For a restaurant, this is your kitchen staff. For a consultancy, it's the consultants delivering client work.
3. Manufacturing Overhead
Indirect costs tied to production: utilities for your workshop, equipment depreciation, rent for your production facility, and quality control. These costs are real but aren't directly traceable to a single unit of product.
COGS vs Operating Expenses
A common mistake is including operating expenses in COGS. Operating expenses (rent for your office, marketing, admin salaries) are not COGS. Only costs directly tied to production belong in COGS.
| COGS (Direct Costs) | Operating Expenses (Indirect) |
|---|---|
| Raw materials | Rent for office/admin space |
| Production labor wages | Sales & marketing salaries |
| Factory utilities | Office supplies & software |
| Shipping/freight in | Advertising & promotions |
Why COGS Matters
- Gross profit calculation — Gross Profit = Revenue - COGS. Without accurate COGS, you don't know your true gross margin.
- Pricing decisions — If you don't know your cost per unit, you can't price profitably. COGS is the floor for your pricing.
- Tax deductions — COGS is a deductible business expense. Accurate COGS tracking can significantly reduce your tax liability.
- Inventory management — Tracking COGS helps you identify which products are most profitable and which are dragging down margins.
Industry Average COGS as % of Revenue
| Industry | Typical COGS % |
|---|---|
| Manufacturing | 50-70% |
| Retail | 40-60% |
| Restaurant | 28-35% (food cost only) |
| Construction | 60-80% |
| Software/SaaS | 15-25% (hosting & support) |
| Service Business | 15-35% |
Source: Industry averages based on public financial data and small business benchmarks. Your actual COGS will vary based on business model, scale, and efficiency.
Try Our Free COGS Calculator
Enter your materials, labor, and overhead costs to calculate your total COGS and cost per unit instantly.
Open COGS Calculator →Frequently Asked Questions
What is the COGS formula?+
COGS = Beginning Inventory + Purchases (or Production Costs) − Ending Inventory. For manufacturers and service businesses without physical inventory, COGS = Materials + Direct Labor + Manufacturing Overhead. The result is the total direct cost of what you sold during the period.
What is included in COGS?+
COGS includes only the direct costs of producing your products or delivering your services: raw materials, components, direct labor wages, manufacturing overhead (factory rent, equipment depreciation, factory utilities), and freight-in. It does NOT include administrative salaries, marketing, office rent, or other indirect operating expenses.
What is NOT included in COGS?+
Operating expenses that are NOT part of COGS: office rent, marketing and advertising, sales team salaries (unless they directly produce the product), administrative staff, general business insurance, and bank fees. These go below gross profit on the income statement as 'operating expenses.'
How do I calculate COGS for a service business?+
Service businesses without physical inventory use: COGS = Direct Labor (hours worked × hourly cost for staff delivering the service) + Direct Materials (consumables used in service delivery) + Subcontractor costs. For a consulting firm, COGS is the salary cost of consultants on client projects. Administrative and sales staff are operating expenses, not COGS.
How does COGS affect gross margin?+
Gross Profit = Revenue − COGS. Gross Margin % = Gross Profit ÷ Revenue × 100. If revenue is $100,000 and COGS is $60,000, gross profit is $40,000 and gross margin is 40%. Reducing COGS by 5% (to $57,000) raises gross profit to $43,000 and margin to 43% — a significant improvement without increasing sales.
What is the difference between COGS and cost of revenue?+
They are often used interchangeably, but 'cost of revenue' is more common for service and software companies. 'COGS' traditionally refers to the cost of physical goods sold. Both appear in the same line on the income statement and are calculated the same way — direct costs of what was sold in the period.