Cost Of Goods Sold: What It Is And How To Determine It

A product or service with a high profit margin might seem promising at first, but it only tells part of the story.

An important part of starting a business is understanding the full picture, which is the real, unfiltered truth about your financial health and what you’re actually taking home in profit.

That’s where the cost of goods sold (COGS) comes in. This lesser-known but critical metric provides a comprehensive view of your finances, taking into account all relevant factors.

In this article, we’ll break down everything you need to know about COGS – what it is, why it matters, and how understanding it can help you build a smarter pricing strategy.

💡Key takeaways

Cost of goods sold (COGS) is the total cost of producing or delivering products or services your business sells.
Common COGS include raw materials, labour, and packaging and shipping.
COGS helps you understand how much it actually costs to produce what you sell, and where you could be overspending.
The three most common methods to calculate your COGS are weighted average, first-in-first-out (FIFO) and last-in-first-out (LIFO).

In this article, we will cover:

What is cost of goods sold?
Why is COGS important?
What's the difference between COGS and other costs?
How to calculate COGS
How to manage your COGS during inflation

What is cost of goods sold (COGS)?

Cost of goods sold (COGS) refers to the total expenses incurred in the production of goods or services that a company sells.

COGS encompasses all costs directly associated with manufacturing or acquiring products, including raw materials, direct labour costs, manufacturing overheads, and selling and administrative expenses such as processing fees. An infographic detailing examples of business overheads

As with many business-related expenses in 2025, COGS-related expenses have increased. According to the Office for National Statistics (ONS), 29% of trading businesses in the UK reported a price increase for goods and services purchased in February 2025.

Therefore, it’s more important than ever to keep a close eye on your COGS, as it can help you maintain healthy profit margins, price your products properly, and make smarter decisions about where to cut back or invest.

Factors that determine COGS

To summarise the factors related to your COGS number, you must consider:

Direct costs: raw materials (e.g. ingredients for a restaurant business, wood for furniture or fabric for clothing).
Direct labour: the wages paid to employees directly involved in the production process.
Manufacturing overheads: costs associated with production, such as utilities, rent, and depreciation of equipment.
Packaging and shipping: the cost of packaging materials and shipping goods to customers (if these costs are directly tied to the product being sold).

Why is COGS important?

It’s crucial to understand your COGS because it gives you a real, in-depth understanding of what your pricing strategy truly should be in order to get the best out of your business. This will be different for every business owner, of course.

Knowing your COGS helps you figure out how much profit you’re actually making on each sale, not just the top-line revenue. Moreover, it helps you spot areas where you might be overspending, set accurate financial goals, and make smarter decisions when it comes to things like discounts, promotions, or scaling up.

Fictional example: Tasty Bites

Tasty Bites was a well-loved restaurant with a loyal customer base and solid reviews. With hopes to stand out in a competitive market, the owners invested heavily in a high-end renovation – splurging on luxury decor, new kitchen equipment, and upscale furnishings.

While the revamped space impressed customers, the costs quickly piled up. The renovation drained their financial reserves and led to higher operating expenses and COGS. To cover these, they raised menu prices, but that only ended up turning away regulars.

Despite the new look, the restaurant struggled to balance rising costs with declining footfall. Within a few months, Tasty Bites was forced to close its doors. This serves as a reminder that while upgrades can boost appeal, they need to be financially sustainable, especially in industries with tight margins like hospitality.

Understanding COGS also helps with resource allocation, ensuring that the right investments are made in areas that generate the highest returns, and that you are always prioritising the things that are the most important for your business.

COGS also plays a crucial role in financial reporting. It is a vital component of financial statements, such as the income statement. Accurate reporting of COGS provides transparency and allows investors, lenders, and stakeholders to assess the company’s financial health. It demonstrates how efficiently the company manages its costs and the impact it has on overall profitability.

What’s the difference between COGS and other costs?

When running a business, it’s important to know where your money’s actually going. Not all costs are the same, and understanding the difference between COGS, cost of revenue, operating expenses, and capital expenses can help you figure out what’s eating into your profit margins – and what’s just part of keeping things running.

Cost of Revenue

This refers to all the direct costs involved in delivering your product or service to customers. It’s similar to COGS, but a bit broader as it includes both the cost of producing goods, plus additional expenses directly tied to service delivery, such as shipping and customer support.

What’s included in the cost of revenue depends on your business model, but here are some common examples:

Business type	Costs included
SaaS/digital businesses	Hosting/server, platform maintenance, customer support staff, third-party software, payment processing
Service-based businesses (e.g. agency or consultancy)	Client-facing staff salaries, travel (related to client work), tools for service delivery (e.g. design software and subscriptions)
Product businesses (e.g. ecommerce)	COGS, shipping/handling, payment processor, warehouse staff wages, packaging

Operating expenses (OPEX)

These are indirect costs of running your business – AKA things you need to keep the lights on, but aren’t directly linked to making or delivering the product. OPEX typically includes:

Rent
Utilities
Marketing and advertising
Salaries for admin or customer support
Software subscriptions (e.g. accounting software)
Office supplies

Capital Expenditures (CapEx)

Refers to the costs related to buying or upgrading long-term assets that help your business operate over time, rather than being used up right away. For example, this could include equipment, property, vehicles and machinery.

How to calculate COGS

There are three distinctive methods to calculate your COGS, and your strategy should depend on the specific dynamics of your business: the weighted average method, FIFO, or LIFO.

We’ll examine each in turn below. Whichever you choose, the goal is to accurately reflect the cost of goods sold and make informed decisions to ensure your business’s financial health and success.

The “weighted average” method

Instead of tracking the exact cost of every item, the weighted average method finds the average cost of all items in stock, based on how much you paid for them and how many you purchased.

Example of the weighted average method

100 units at £5 = £500
200 units at £6 = £1,200
Total: 300 units at a total cost of £1,700

Weighted average cost per unit = £1,700 ÷ 300 = £5.67

Outcome: whether you sell one item or 50, you’ll record each sale using that £5.67 cost.

The “first-in, first-out” (FIFO) method

The FIFO method is a way of calculating the cost of inventory by, as the name suggests, going by the idea that the oldest stock gets sold first. In other words, when you sell a product, it’s assumed to come from your earliest batch of stock, and the cost recorded for that sale is based on what you paid for that older inventory.

Example of the FIFO method

Let’s say you bought:

100 units at £5 = £500
100 more units at £6 = £600

You then sell 120 units. Using the FIFO method, you’ll calculate costs like this:

First 100 units = £5 each → £500
Next 20 units = £6 each → £120
Total cost of goods sold = £620

The remaining 80 units from the 200 you purchased are valued at the new £6 cost.

The “last-in, first-out” (LIFO) method

This is another way of calculating the cost of inventory. However, unlike the FIFO method, LIFO assumes that the newest stock gets sold first. So when you sell something, it’s recorded as coming from your most recent (and usually more expensive) purchases.

Example of the LIFO method

Let’s say you bought:

100 units at £5 = £500
100 more units at £6 = £600

You then sell 120 units. Using the LIFO method, you’ll calculate costs like this:

First 100 units = £6 each → £600
Next 20 units = £5 each → £100
Total cost of goods sold = £700

That leaves 80 units from the older £5 batch still in inventory.

Extended Producer Responsibility (EPR)

Introduced under the Environment Act 2021, businesses with an annual turnover of £1 million or more must collect and report packaging data if they handle more than 25 tonnes of packaging per year.

This is part of the UK Government’s Extended Producer Responsibility (EPR) scheme, which could mean an increase in operational expenses, especially if you’re using a lot of plastic or non-recyclable packaging. There may also be added admin costs for tracking and reporting data, upgrading systems, or switching to more eco-friendly packaging materials to reduce future fees.

How to manage your COGS during inflation

In today’s economy, small businesses are struggling with overheads, and tough inflation has a big impact on the cost of goods sold. As a result, 74% of business owners are set to increase their prices in the next 12 months.

While inflation is beyond a business owner’s control, it demands careful consideration and proactive measures. There are several factors that contribute to rising COGS due to inflation, including:

Increased prices of raw materials: during inflation, the prices of raw materials or ingredients can rise, affecting the overall production costs.
Increased labour costs: rising wages and labour expenses can escalate the cost of goods sold, particularly in labour-intensive industries or premises that need a high number of staff.
Reduced profits: higher COGS can lower a company’s gross profit margin, potentially reducing overall profitability.
Increased prices for customers: businesses may be forced to pass on increased costs to customers through higher prices, potentially impacting customer satisfaction and demand.

But while inflation inevitably puts pressure on your costs, there are some practical strategies businesses can use to manage their COGS and protect their profits. Here are some ways you can tackle rising costs head-on.

1. Negotiate with suppliers

Building strong, long-term relationships with your suppliers can help you negotiate better prices, bulk discounts, or more flexible payment terms. Even small savings per unit add up, especially when you’re buying large volumes.

2. Find alternative suppliers

Don’t be afraid to shop around. Sometimes, sourcing raw materials or components from different suppliers or regions can cut down the costs. Just make sure that the quality is still up to a good standard, and try not to rely too heavily on just one supplier.

3. Keep your inventory tight

Holding too much stock can eat up your cash and leave you with waste. However, if you don’t have enough, then you risk running out when you need it most. Use forecasting tools and just-in-time purchasing to keep inventory levels balanced, so that you have enough stock to meet demand without overcommitting on resources.

4. Focus on your most profitable products

When prices are rising, it makes sense to double down on the stuff that earns you the most, especially during periods of inflation. You could also consider temporarily pausing or reducing lower-margin products to keep your overall profits healthier.

5. Keep an eye on your pricing

If your costs are going up, your prices might need to go up too. But don’t just set it and forget it. Instead, review your pricing regularly so that it reflects what’s happening in your business and the market – even small changes like bundling or loyalty discounts can help ease the impact for customers.

Conclusion

COGS might not be the flashiest topic in the world, but it’s one of the most important numbers for any business owner to understand. After all, it gives you a clearer picture of what you’re really spending to make and sell your products – and ultimately, how much profit you’re actually bringing in.

The better you understand your COGS, the easier it is to price things right, spot where you’re overspending, and stay on top of your profits – especially when inflation and rising costs are making things trickier than usual.

Whether you’re just starting out or looking to tighten up your finances, understanding and managing your COGS is key to building a healthier and more resilient business.