Cost of goods sold refers to the direct costs a business incurs to produce or acquire the goods it sells during a specific period. It is one of the most important figures on the income statement because it sits directly below sales revenue and determines gross profit.
By isolating the costs directly tied to products sold, cost of goods sold helps businesses understand how efficiently they are generating return from their core operations. Whether a company is reselling inventory or manufacturing products, accurate COGS tracking is essential for pricing, profitability, and financial reporting. It also supports decisions around cost control↗, financial KPIs↗, and financial planning and analysis↗.
At a practical level, cost of goods sold is sometimes also described as cost of sales or cost of sale, especially in external reporting or sector-specific language. In some business models, particularly digital or service-heavy ones, teams may also compare it with cost of revenue. Whatever term is used, the goal is the same: to measure the cost attached to goods actually sold, not simply purchased or produced.
What does cost of goods sold include?
Cost of goods sold includes the direct costs required to produce or acquire goods. For a manufacturer, that often means raw materials, direct materials, direct labour, direct labour costs, and manufacturing overhead. For a retailer, it usually includes the purchase price of inventory plus any directly attributable shipping costs needed to bring goods into saleable condition.
This is where businesses need to separate product-related costs from broader operating expenses. Expenses such as office rent, many sales commissions, most sales and marketing spend, and support salaries are usually treated as operating expenses, not as cost of goods sold. The same applies to hosting fees for many software companies, depending on the reporting approach. In some service businesses, finance teams may instead track cost of revenue, which can include the cost of time spent on all services or projects, certain subcontractor costs, and other delivery-related expenses.
In manufacturing, the distinction can be more nuanced. Some production costs belong in COGS, while others fall under overhead costs or general operating expenses. For example, the cost of raw materials, some labor costs, payroll taxes tied to production staff, and a share of depreciation expense may be included, while unrelated admin salaries are not. Businesses also need to consider factory overhead, work in progress, and the wider production process when deciding what should be capitalised into inventory and what should be expensed immediately.
Cost of goods sold vs operating expenses
A common point of confusion is the difference between cost of goods sold and operating expenses. Both represent costs incurred by the business, but they serve different purposes in reporting.
COGS relates specifically to the goods sold during the period. operating expenses relate to running the business more broadly. Examples of operating expenses include marketing, office costs, software subscriptions, and support salaries. They can also include sales commissions, sales and marketing activity, and other sales costs that help generate demand rather than produce inventory. These are deducted after gross profit is calculated, which is why the distinction matters.
This separation helps explain profitability. A business may have a healthy gross profit and still underperform overall if operating expenses are too high. Equally, a company with tight control over operating expenses can still struggle if cost of goods sold, cost of revenue, or cost of sales rises sharply due to higher raw materials, weaker supplier terms, or higher overhead costs.
Inventory methods and cost of goods sold
The accounting method a company uses for inventory has a direct effect on cost of goods sold. Different approaches decide which inventory costs are recognised first, especially when prices change over time. That is why COGS is closely linked to inventory valuation and the chosen inventory valuation method.
The most common methods include first in, first out, last in, first out, and weighted average. Under First in, first out, the oldest inventory costs are recognised first. Under last in, first out, the newest costs are recognised first, although that method is not allowed in all jurisdictions. Under the average cost method, or weighted average, inventory is valued based on an average cost across units rather than the exact order of purchase.
Some businesses also use specific identification, especially where items are high-value or individually traceable. Under specific identification, each unit is assigned its actual cost, which creates a different cost flow pattern from FIFO or weighted average. This matters because the chosen inventory valuation method affects cost of goods sold, cost of revenue, and reported profit. In periods of rising prices, FIFO often produces lower COGS and higher reported profit, while other methods may increase COGS and reduce short-term profit. That is why the chosen accounting method matters when comparing companies or analysing trends in financial statements.
Inventory and financial statements
COGS connects inventory on the balance sheet to expense recognition on the income statement. Inventory stays on the balance sheet as an asset until it is sold. Once sold, its value moves out of inventory and becomes cost of goods sold on the income statement.
This means that beginning inventory and ending inventory are not just calculation inputs; they are also important reporting figures. Ending inventory affects the value of current assets, while beginning inventory anchors the movement from one accounting period to the next. Errors in either figure can distort financial statements, overstate or understate gross profit, and weaken confidence in the company’s financial health.
That is why strong inventory management matters. Businesses with weak inventory controls often struggle with stock inaccuracies, valuation errors, obsolete inventory, or delayed reporting. Better systems improve inventory valuation, reduce surprises, and facilitate easier work for the financial controller↗.
Cost of goods sold in different business models
COGS is most relevant for businesses that sell physical goods, but how it is calculated can vary. A manufacturer may include raw materials, direct costs, production costs, and manufacturing overhead. A retailer may focus mainly on purchase price, freight, and directly attributable inventory costs. In both cases, cost of sales remains a core indicator of efficiency.
Service businesses are different. They may not always report traditional cost of goods sold, but some use a similar concept to capture the direct cost of delivering a service. In these cases, cost of revenue may be a more common label than COGS. It can include delivery-related staffing, subcontractor costs, or the cost of time spent on all services or projects. The right treatment depends on the company’s accounting method, reporting framework, and internal management approach.
This is why there is no one-size-fits-all model. The exact composition of COGS, cost of revenue, or cost of sale depends on the business, the industry, and how the organisation structures its reporting. Still, in any sector, accurate tracking helps teams understand financial health, pricing pressure, and operational efficiency.
How businesses can improve cost of goods sold
Improving COGS does not always mean cutting corners. Often it means getting better visibility into procurement, production, and stock movement. Companies typically focus on supplier pricing, production efficiency, waste reduction, and stronger inventory management to lower COGS without harming quality.
For some businesses, that means better purchasing control by using purchase orders↗ and improving the wider procurement process↗. For others, it means improving stock accuracy, reducing obsolete items, and limiting storage costs through better planning.
Digital tools can also help. Businesses investing in spend management software↗, modern accounting technology↗, and other software tools for CFOs↗, often gain better cost visibility and faster reporting. That in turn supports better decisions around sales revenue, product pricing, and margin performance.
Summary
Cost of goods sold measures the direct costs of the goods a business sells during a period. It is calculated using beginning inventory, purchases, and ending inventory, and it appears near the top of the income statement because it directly determines gross profit and gross margin.
Accurate COGS tracking improves pricing, reporting, and operational decision-making. It also strengthens the quality of financial statements, supports a more reliable balance sheet, and gives businesses a clearer view of gross profit, net income, sales revenue, and overall financial health. When companies understand their cost of goods sold, cost of revenue, and related cost structure, they are better placed to manage margins, control operating expenses, and make smarter strategic decisions.