Understanding Cost of Goods Sold (COGS): Definition and Implications

June 14, 2024
12 min read

When it comes to the pillars of financial analysis for any business, particularly small and medium-sized eCommerce enterprises, understanding the Cost of Goods Sold (COGS) is imperative. This metric is not just a line item on an income statement – it serves as proof of a company's operational efficiency and directly influences profitability. 

In this blog post, you’ll gain a thorough understanding of COGS, including its numerous components and the costs that make up the statistics. We'll also talk about the expenses that are not covered while we're at it. 

COGS: What Is It?

Let's start with the basics. 

COGS includes all direct costs tied to producing goods your business sells. Unlike operating expenses that cover overheads like admin and marketing, COGS only includes production-related expenses.

Consider this: if you had a bakery, COGS would consist of the price of flour, sugar, and the salaries given to the bakers. It wouldn't pay for your marketing manager's salary or the cost of advertising your bakery. You may determine how much it really costs to produce the things you sell by isolating these costs, which is important information for pricing and profit calculations.

Components of COGS

COGS primarily includes:

  • Raw Materials: These are the core ingredients used to make your products. For a manufacturer, this could be metals for hardware. For a bakery, it's flour and sugar. Without raw materials, you simply can't produce your goods. Keeping track of these costs helps you understand how much you're spending to get your products off the ground.
  • Direct Labour: This includes wages paid to employees directly involved in making products, like assembly line workers or craftsmen. Direct labour costs are straightforward but can add up quickly. Every hour a worker spends making a product is a cost that needs to be accounted for. Accurate tracking of direct labour ensures you understand the human effort behind your products.
  • Manufacturing Overheads: These are production-related costs that aren't tied to a specific product unit, such as machine maintenance, factory rent, and utilities. These costs might not be as obvious as raw materials or direct labour, but they are crucial to your production process. Keeping machines running smoothly and lights on in the factory are all part of manufacturing overheads.
  • Packaging: Materials used to package products for sale, like boxes, tape, and protective wrapping. Packaging ensures your products reach customers in good condition, and these costs should be factored into COGS. Quality packaging can also enhance the customer experience and reduce returns due to damaged goods.
  • Freight and Transportation: Costs for transporting materials or finished goods to the point of sale. Whether it's getting raw materials to your factory or shipping finished products to retailers, transportation costs are a significant part of COGS. Efficient logistics can help reduce these costs and improve your bottom line. 

For deeper insights on how these costs contribute to overall fulfilment expenses, explore our fulfilment costs analysis.

What Is Excluded From COGS

While the cost of goods sold encompasses all direct expenses related to the production of goods, several costs are categorically excluded. Hence, understanding what does not fall under COGS is just as important for accurate financial reporting and strategic planning. 

Here are some typical exclusions:

  • Marketing and Advertising Expenses: These are the costs associated with promoting products and services. Whether it's digital advertising, print media, or public relations events, these expenses are classified as operating costs, not direct production costs.
  • Administrative Costs: Salaries of executive and administrative personnel, office supplies, and other general expenses are not included in COGS. These are necessary for running the business but are not directly tied to the manufacturing or sale of specific products.
  • Research and Development (R&D): Investments in R&D for new products or improvements are crucial for business growth but are accounted for separately from COGS. These costs are considered capital expenditures or operational expenses, depending on their nature.
  • Sales Commissions: Although directly related to the sale of products, commissions paid to sales staff are not included in COGS. Instead, they are recorded as selling expenses.

Calculating COGS

Now, let’s take a look at the formula and step-by-step breakdown of how COGS is typically calculated.


COGS Formula: Beginning Inventory + Purchases − Ending Inventory = COGS

Component Explanation 

Beginning InventoryRepresents the value of all inventory held at the start of the fiscal period, including costs carried over from previous periods.
PurchasesIncludes any additional inventory bought during the period, whether raw materials or finished goods, along with all expenses incurred to bring the inventory to a saleable state, such as shipping and handling.
Ending InventoryThe value of unsold inventory is subtracted at the end of the period assessed during a physical inventory count or through perpetual inventory systems.

Example Calculation

Suppose a company starts the year with £100,000 in inventory, purchases £300,000 worth of new stock during the year, and ends the year with £80,000 in unsold inventory. The COGS would be calculated as follows:

£100,000 + £300,000 − £80,000 = £320,000

This £320,000 represents the direct costs tied to the goods sold during the year, not including operational expenses like salaries and utilities.

The Importance of Accurate COGS Calculation

Accurate COGS calculation is more than just a numbers game. It’s about understanding your business's financial health and making informed decisions. 

Profit MarginsKnowing the cost of goods sold helps you set prices that cover costs and ensure profitability. If your COGS is too high, your profit margins will shrink. Conversely, having a good understanding can help you find ways to reduce costs and improve margins.
Inventory ManagementAccurate COGS calculation aids in managing inventory levels. Knowing the cost of unsold goods helps in making decisions about stock levels, reorder points, and clearance of old stock. Efficient inventory management can prevent overstocking and stockouts, both of which can be costly.
Budgeting and ForecastingUnderstanding your COGS allows for better budgeting and financial forecasting. It helps predict future costs and set realistic financial goals. This can be especially important when planning for expansion or new product lines.
Tax ReportingAccurate COGS calculation is crucial for tax reporting. It affects your taxable income and, consequently, your tax liability. Overstating or understating COGS can lead to legal issues and financial penalties. For businesses operating in the US, understanding the implications of COGS on US sales tax is highly important.

Impact of COGS on Financial Statements and Business Decisions

The cost of goods sold has a significant impact on both the financial statements and strategic decisions of a business. 

1. Financial Statements

  • Gross Profit: COGS is deducted from total revenues to calculate the gross profit. A lower COGS can lead to a higher gross profit, which is essential for a healthy bottom line.

  • Profit Margins: Calculating COGS helps businesses maintain healthy profit margins. It directly affects the gross margin and, consequently, the net profit margin, providing a clear picture of financial health.

2. Business Decisions

  • Pricing Strategy: Knowledge of COGS helps businesses set competitive yet profitable pricing. Understanding the direct costs of products ensures pricing covers costs effectively, which is crucial for long-term sustainability.

  • Inventory Management: Effective management of COGS aids in optimising inventory levels. By understanding the costs associated with goods, businesses can make informed decisions about stock levels, reorder points, and clearance of old stock.

  • Cost Control: Monitoring COGS enables businesses to identify areas where cost savings can be made without compromising quality. This could mean negotiating better prices with suppliers or finding more cost-effective manufacturing methods.

5 Practical Tips for Managing COGS

Managing COGS effectively requires a strategic approach. Here are some practical tips to help you keep costs under control:

  1. Regularly Review Supplier Contracts: Negotiating better prices with suppliers can significantly reduce raw material costs. Regularly reviewing and renegotiating contracts can lead to cost savings.
  2. Optimise Production Processes: Streamlining production processes can reduce direct labour and manufacturing overheads. Implementing lean manufacturing techniques can improve efficiency and reduce waste.
  3. Invest in Technology: Utilising technology for inventory management and production planning can enhance accuracy and efficiency. Automated systems can help track inventory levels, predict demand, and manage production schedules effectively.
  4. Monitor Market Trends: Keeping an eye on market trends can help you anticipate changes in raw material prices and adjust your purchasing strategy accordingly. This can prevent unexpected cost increases and maintain profitability.
  5. Conduct Regular Audits: Regular audits of your production and inventory processes can identify inefficiencies and areas for improvement. Audits can also ensure compliance with industry standards and regulations.

How Bezos Can Help Manage COGS for SMEs

Logo of Bezos.

In the intricate world of eCommerce, small and medium-sized enterprises (SMEs) often face significant challenges in managing their cost of goods sold effectively. Bezos offers tailored solutions that streamline the complexities associated with COGS, ensuring businesses can optimise their financial and operational strategies efficiently. 

Here’s how partnering with Bezos can benefit your business:

Advanced Inventory Management

Bezos's sophisticated inventory management system helps businesses maintain optimal stock levels, reducing unnecessary storage costs and minimising the risk of stockouts. By keeping a precise tab on inventory, SMEs can better manage their COGS and improve cash flow.

Efficient Fulfilment Operations

With our global network of fulfilment centres, businesses can reduce their freight and transportation costs – a significant component of COGS. Bezos ensures that products are stored closer to customers, which not only lowers shipping costs but also speeds up delivery times, enhancing customer satisfaction.

Scalable Logistics Solutions

Whether you are expanding locally or internationally, Bezos provides scalable logistics solutions that grow with your business. This flexibility helps SMEs manage operational costs more effectively, keeping COGS in check without hindering expansion efforts.

Transparent Costing

We offer complete transparency in its pricing structure, which aids businesses in accurately forecasting their COGS. This clarity is crucial for setting realistic price points and maintaining healthy profit margins.

Dedicated Support

Bezos's dedicated account managers provide expert guidance on optimising logistics operations, which can significantly influence the components of COGS, such as direct labour and overhead costs. This support is vital for SMEs that might not have extensive logistics expertise in-house.

But don't just take our word for it. Our case studies, like the success of 'Enjoy The Drop,' showcase our ability to revolutionise logistics. This supplement brand saw a 50% reduction in fulfilment costs and a 12-fold growth since partnering with Bezos, alongside saving three hours daily in operational tasks. 

Speak to a Bezos expert today!

Conclusion: Leveraging COGS for Strategic Business Advantages

By meticulously tracking and controlling the direct costs associated with producing goods, businesses can optimise pricing strategies and enhance inventory management, thereby increasing their bottom line. Partnering with Bezos further streamlines this process, offering advanced inventory solutions, efficient fulfilment operations, and scalable logistics tailored to your business needs. Embrace these services to effectively manage the cost of goods sold and drive strategic growth and competitiveness in the market, ensuring both short-term profitability and long-term success.

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