Cost of Goods Sold (COGS)
The direct costs of producing what you sell—materials, production labor, or subcontractors—subtracted from revenue to get gross profit.
Definition
Cost of goods sold (COGS) is the direct cost of producing whatever you sell. For a product business, that's materials, manufacturing, and freight for the units sold. For service businesses, the same idea is often labeled cost of sales or cost of services: subcontractor fees, project-specific software, printing, or stock assets—costs that exist only because a particular job exists. Revenue minus COGS equals gross profit.
The dividing line is directness. The $2,000 you pay a subcontractor to deliver part of a client project is COGS; your own rent, accounting software, and marketing are operating expenses, because you'd pay them whether or not that project existed. Keeping the two separate on your income statement is what makes gross margin—the profitability of the work itself—visible before overhead muddies the picture.
Why It Matters
COGS is the foundation of pricing. If a $10,000 project carries $6,500 of subcontractor and materials cost, your gross margin is 35%—and that margin has to cover all your overhead and your own pay. Tracking COGS per project or service line shows you which work is actually worth doing; plenty of businesses discover their busiest offering is their least profitable once direct costs are properly assigned.
It matters for taxes too. Product sellers must calculate COGS using inventory—you deduct the cost of goods when they're sold, not when you buy stock—so inventory left on the shelf at year-end isn't deductible yet. Misclassifying costs between COGS and operating expenses won't usually change total profit, but it will distort your margins and any benchmark comparisons you make.
Examples
- 1
A design agency bills $12,000 for a website and pays a developer $5,000 to build it; the $5,000 is COGS, leaving $7,000 gross profit.
- 2
A print shop sells $8,000 of merchandise in a month with $3,200 in blanks, ink, and shipping—a 60% gross margin before overhead.
- 3
A maker buys $10,000 of inventory in November but sells only $4,000 worth by year-end; just $4,000 counts as COGS this tax year.
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