What is cost of goods sold and how do you calculate it? Here’s how to maximise profits by calculating your cost of goods sold, and uncover its impact on your business's overall financial health. Written by Stephanie Lennox Updated on 24 July 2023 Our experts We are a team of writers, experimenters and researchers providing you with the best advice with zero bias or partiality. Written and reviewed by: Stephanie Lennox Writer You know how in Dragon's Den they get all excited when they hear a product with a high profit margin? That's great and all, but it only tells half the story. If you want the real, unfiltered truth about your financial health and the actual profits, there's something far more important you need to know: the cost of goods sold (COGS). This lesser-known but critical metric gives you the full picture of what's really going on with your finances when absolutely everything has been taken into account.In this article, we'll take you on a journey to demystify COGS. We'll break it down so you can understand why it's essential, and how to calculate it effectively. By the end, you'll have the clearest insight into your business's financial health, empowering you to make informed decisions, increase profitability, and impress potential investors with a comprehensive grasp of your outgoings. In this article, we will cover: What is cost of goods sold? Why is COGS important? How to calculate COGS How to manage your COGS during inflation Four questions to consider to reduce your COGS Conclusion FAQs 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 – including indirect costs that you may not consider immediately at first thought.It 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.Factors that determine COGS:To summarise the factors related to your COGS number, you must consider:Direct costsThese are costs directly related to the production of goods or services, which include:What raw materials are needed? the materials used to create the final product, such as ingredients for a restaurant, wood for furniture or fabric for clothing.How much direct labour is needed? the wages paid to employees directly involved in the production process.What are the manufacturing overheads? indirect costs associated with production, such as utilities, rent, and depreciation of equipment.Indirect costsThese are expenses that support the overall production process but are not directly attributable to individual products, and they include:Selling expenses: costs incurred to promote and sell your products, such as advertising and sales commissions.Administrative expenses: overhead costs associated with general business operations, including supplies and salaries of non-production employees.Now let’s put this all together:Let’s say you’re making a pie. Baking the pie itself, then delivering it to your customer seems like a simple enough process, right?However, when you’re considering your COGS, and the ultimate profitability of that pie, you have to think like this: You need to have your raw ingredients costed up (such as flour, eggs, milk etc) It costs you an employee's labour, and their paid time, to bake the pie. You will need to use your place of business for the employee to bake in (which will involve all the associated lighting, heating and running costs)And you will have costs associated with serving or delivering that pie (whether that’s costs for crockery, cutlery and napkins in a restaurant, or for paying a delivery driver or delivery fee, for example). 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.Most business owners immediately think that selling more expensive products may bring more profit. But this isn’t necessarily true if the cost of creating, storing and/or prepping those products is going to cost you and your employees an overwhelming amount of labour, time or (worst case scenario) disposal rate if your product is something that has a short usage date.When it comes to decision-making, having a clear understanding of COGS is essential because it enables businesses to make better-informed choices. Tasty Bites: the restaurant Let's consider the example of a fictional restaurant called “Tasty Bites.”Tasty Bites was a popular eatery known for its delectable menu and cosy ambiance. The business was doing reasonably well, attracting a steady stream of customers and earning favourable reviews. However, in an attempt to elevate their image and stand out in the competitive market, the owners decided to undertake a major renovation of the entire restaurant.The renovation was extravagant, involving expensive interior design, high-end furnishings, and cutting-edge kitchen equipment. The total cost of the renovation amounted to a substantial portion of the restaurant's financial reserves, but the owners were confident that the investment would pay off with increased customer attraction and higher profits.Unfortunately, things didn't go as planned. While the renovated restaurant looked stunning and garnered praise from patrons, the financial implications started to take a toll on the business. The increased costs of the renovation led to a spike in their operating expenses and, consequently, a rise in their COGS.The owners failed to appreciate that the higher COGS, coupled with the ongoing maintenance expenses of the luxurious furnishings and equipment, significantly ate into their profit margins. Despite the positive feedback on the new look, the higher menu prices they had to charge to cover these expenses deterred some of their loyal customers.As a result, Tasty Bites experienced a drop in the number of repeat customers and a decline in overall footfall. The owners found themselves in a difficult position, unable to maintain the hefty costs associated with the renovation while trying to generate enough revenue to sustain the business.In the end, the excess spending on the extravagant renovation proved to be a huge mistake. The financial strain and inability to turn a sustainable profit led to Tasty Bites closing its doors just a few months after the renovation.This example highlights the importance of striking a balance between investment and return, especially in the hospitality industry. While upgrades and improvements are essential to stay relevant, businesses must carefully evaluate the potential impact on their financial health. Being conscious of how expenditures affect COGS and overall profitability is critical to avoiding such pitfalls and ensuring the long-term success of the business. 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.Accounting software for small businesses is a must for this. To learn more about how the top accounting software contenders stack up in terms of cost, features, ease of use and customer support, you can check out the options in the table below: Swipe right to see more 0 out of 0 backward forward BEST OVERALL 90% OFF DEAL QuickBooks FreshBooks Xero Clear Books Zoho Books Price From £10 per month 90% off for 6 months Price From £12 per month 50% off for 3 months Price From £12 per month (excl. VAT) Price From £12.00/mo £6.00/mo *first 3 months (excl. VAT) Price From Free, or £12 per month (excl. VAT) Rating 4.7 Rating 4.0 Rating 4.6 Rating 4.2 Rating 4.0 Free Trial Free Trial Free Trial Free Trial Free Trial Compare accounting software and find the right deal for you Compare now How to calculate COGS COGS = cost of materials + cost of labour + manufacturing overhead 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” methodImagine an ice cream parlour – this is a good example business where the weighted average method for calculating COGS would be appropriate.The ice cream parlour offers a variety of ice cream flavours throughout the year. Some flavours have consistent prices, while others are seasonal and may vary in cost based on ingredients' availability. The ice cream parlour purchases fresh strawberry flavour ingredients at a higher price during the off-season but at a lower price during the peak strawberry season. The weighted average method calculates COGS by considering the quantity of strawberries bought at each price, ultimately giving a cost per unit that considers all purchases over the year. The method is ideal for this business because it smoothes out the fluctuations in ingredient costs, providing a more stable and accurate representation of COGS.The “first-in, first-out” (FIFO) methodThe FIFO method is particularly relevant in industries that involve time-sensitive goods. This approach aligns well with the clothing industry, where trends change rapidly, and you want to ensure that older stock is sold before it becomes outdated or less desirable.So for example, imagine you own a trendy boutique that sells a wide variety of fashion apparel (time-sensitive goods). As a clothing retailer, you regularly receive new shipments of “fresh off the runway” clothing items from various suppliers. To effectively manage your inventory and optimise your COGS, implementing the FIFO method would be highly suitable.The principle is straightforward: the first items you purchase or receive are assumed to be the first ones sold. Using the FIFO method allows you to accurately assess the cost associated with each item sold, as you account for the oldest purchases first. This information is vital for determining the true profitability of your clothing sales.It can also help you manage your inventory effectively. By selling older stock first, you avoid potential losses due to items becoming obsolete or experiencing decreased demand. This ensures that you maintain a fresh and appealing selection for your customers, increasing the likelihood of generating sales and reducing the need for significant markdowns or clearance sales.FIFO requires diligent record-keeping and tracking of your inventory, both in terms of quantities and purchase dates. Inventory management software or point of sale systems can streamline this process, allowing you to easily identify the oldest items and calculate the corresponding COGS accurately.By adopting this COGS calculation strategy, particularly in a time-sensitive industry, you can make informed decisions about pricing and restocking, and maintain a profitable and appealing inventory. The “last-in, first-out” (LIFO) methodLIFO is most suitable for industries where inventory costs tend to rise over time, such as the technology sector. Let's take an electronics store as an example of an industry where LIFO is appropriate for calculating COGS.In the electronics retail industry, technological advancements often lead to the introduction of newer and more advanced models, and older electronic products become less desirable, decreasing in value. The LIFO method assumes that the most recent inventory purchased is the first one sold. Therefore, when calculating COGS, the cost of the newest inventory (last in) is matched with the cost of goods sold first (first out).For instance, as newer laptop models are introduced, the store purchases additional inventory at higher costs than previous models. With LIFO, the store values the laptops they sell based on the most recent purchase prices. This method allows them to report lower COGS and potentially minimise taxable income during times of rising costs. How to manage your COGS during inflationIn today’s economy, small businesses are struggling with overheads, and tough inflation has a big impact on the cost of goods sold. While inflation is beyond a business owner's realm of control, it demands careful consideration and proactive measures. Failing to take into account its impact on COGS can spell trouble for a company's viability. The dynamics of inflation can lead to a reduced profit margin, decreased competitiveness, and even the risk of operating at a loss.For small businesses, being proactive is key to navigating inflation. When times get tough, it’s important to explore various strategies to cushion the impact on your COGS. This may include reevaluating supplier relationships, seeking cost-effective alternatives, or optimising production processes to reduce waste and inefficiencies.There are several factors that contribute to rising COGS due to inflation: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. Four questions to consider to reduce your COGSThe 80/20 rule, also known as the Pareto Principle, is a concept that originated from the Italian economist Vilfredo Pareto. This suggests that roughly 20% of your actions are driving 80% of your results. This principle has been found to apply in various fields, including business, economics, and productivity, and it holds true in many different scenarios.When related to COGS, it means that there is a chance you could cut up to 80% of your extraneous costs and/or time-wasters without any negative impact on your bottom line. The 80/20 rule can bring huge potential for optimisation and strategic decision-making in your business by helping you to focus your efforts on maximising profitability in key areas. Here are some of the most important factors to consider in managing your COGS:What is your best-selling product or service right now? Recognising the most cost-intensive products enables businesses to optimise their inventory levels. By prioritising the most profitable items, they can avoid overstocking less profitable products, reducing storage and holding costs.How can you garner more attention/promotion for your best-selling product, and reduce your time and energy on others? Concentrating your efforts on reducing costs of high-COGS items allows businesses to negotiate better deals with suppliers, seek alternative sourcing options, or explore ways to improve the production efficiency of these products.What is driving the most and least profit? Understanding which products’ profitability are most affected by COGS can help set appropriate pricing structures. Businesses may choose to price high-COGS items with higher profit margins to add prestige to their business while adopting competitive pricing for low-COGS products to attract customers to offset their costs.Is it possible to find cheaper suppliers? Reach out to multiple suppliers and request quotes specifically for high-COGS products. This process allows you to identify suppliers who offer better deals while maintaining product quality. You can also cultivate strong relationships with suppliers who consistently provide competitive pricing. ConclusionIn today's gruelling economy, keeping a close eye on your COGS is more critical than ever for businesses. Getting a clear handle on your COGS allows you to supercharge your profitability, giving your company the financial edge it needs. Plus, armed with accurate COGS data, you can confidently make informed decisions that steer your business in the right direction, even in the face of rising costs. So, don't underestimate the power of managing your COGS – and don't let yours be a mystery or an afterthought. Embrace it as a powerful tool to steer your business towards prosperity. By staying vigilant about your COGS, you'll be armed with the knowledge and flexibility you need to truly thrive. Frequently Asked Questions What is a formula for COGS? Cost of goods sold (COGS) = cost of materials + cost of labour + manufacturing overhead. Is COGS the same as profitability? No, COGS (Cost of Goods Sold) and profitability are not the same. COGS represents the direct costs associated with producing or purchasing the goods sold by a company. Profitability, on the other hand, is a measure of how efficiently a company generates profits from its total revenue after accounting for all expenses, including COGS. It indicates the overall financial health and success of a business. How can you reduce the cost of goods sold? Reducing the cost of goods sold can be achieved through several effective strategies: you can try to negotiate better deals with suppliers to obtain discounts on raw materials, optimise production processes to minimise waste, and explore alternative sourcing options for cheaper materials (that don't compromise on quality). Closely analysing and adjust pricing strategies can help you maintain healthy profit margins and stay competitive in the market. Share this post facebook twitter linkedin Tags News and Features Written by: Stephanie Lennox Writer Stephanie Lennox is the resident funding & finance expert at Startups: A successful startup founder in her own right, 2x bestselling author and business strategist, she covers everything from business grants and loans to venture capital and angel investing. With over 11 years of hands-on experience in the startup industry, Stephanie is passionate about how business owners can not only survive but thrive in the face of turbulent financial times and economic crises. With a background in media, publishing, finance and sales psychology, and an education at Oxford University, Stephanie has been featured on all things 'entrepreneur' in such prominent media outlets as The Bookseller, The Guardian, TimeOut, The Southbank Centre and ITV News, as well as several other national publications.