03 April 2025
Cost of goods sold: formula and more
5 minutes
A company’s cost of goods sold (COGS) is simply the cost of producing the goods or services it sells. In other words, it’s the expenses a business incurs on its path to grow revenue. You can use a company’s COGS to better understand its profitability and to track underlying efficiencies.
In this guide, we explain:
- The formula for cost of goods sold, and what’s included in its calculation.
- How to calculate COGS, with examples.
- How and where COGS is used.
What is the formula for cost of goods sold?
The formula for COGS is simply:
Cost of Goods Sold (COGS) = (Starting Inventory + Purchases) – Ending Inventory
Importantly, the formula is specific to periods like a quarter or a year. So:
- Beginning inventory is the leftover inventory from the previous period
- The purchases included are for the current period
- The ending inventory is any inventory that isn’t sold during the current period. Adjusting for the ending inventory means you avoid over- or underestimating the actual cost of goods sold.
For example, let’s say you choose the first quarter as your period. This means your starting inventory would be any inventory you have on the 1st of January, and your ending inventory would be the leftover stock on the 31st of March. For purchases, you’d include any made between 1st January and 31st of March.
What is the formula for COGS ratio?
You can calculate a company’s COGS ratio by dividing its COGS by its total sales revenue and expressing the result as a percentage. The formula is:
COGS Ratio = (COGS / sales revenue) x 100
The COGS ratio is helpful because it shows you how much of the revenue generated by your business is being used to cover the direct costs of producing your goods. A lower COGS means your production costs are significantly lower than the revenue from sales, which is a healthy indicator of profitability and growth.
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What is included in the cost of goods sold?
All direct costs associated with producing products or services are typically included in COGS. So, think about if a cost would exist if you didn’t produce a specific product or service. If the answer is no, then this cost probably won’t fall under your cost of goods sold. Here are some costs that are usually included in COGS:
- Certain types of labour costs (we explain which below)
- Raw materials
- Finished products
- Manufacturing overhead costs
- Hosting fees for SaaS companies
When categorising expenses, it’s important to keep the difference between COGS and operational expenditures (OpEx) in mind. The distinction is important because, depending on your industry, a cost may fall under OpEx instead of COGS, or vice versa. OpEX includes costs that aren’t directly tied to production, such as rent or utility costs.
Labour costs are the most straightforward example of how the distinction can vary. For services-orientated businesses, where labour is essentially the product, the cost of direct labour for services they provide falls directly under COGS. (Note: since services businesses don’t technically have “products”, they often refer to COGS exclusively as the cost of sales)
But the wages of administrative and marketing staff may fall under OpEX, in both goods and services companies, because they’re not directly related to the costs of producing goods or services. The exception is if you provide an administrative resource or marketing services.
How to find the cost of goods sold
You’ll usually find a company’s cost of goods sold on its income statement, right after its sales revenue. If you can’t find the COGS, you can calculate it by subtracting the company’s revenue from its gross profit (they’re both included in the income statement).
How to calculate cost of goods sold (with examples)
The basic principle for calculating COGS is simple: you add up your starting inventory, purchase, and ending inventory for a specified period. Then, you subtract your ending inventory from your starting inventory and purchases, and the result is your cost of goods sold.
Here’s how you’d calculate COGS for a products and services company, respectively.
1. Example 1: Calculating COGS for a products company
Let’s say you want to calculate the cost of goods sold for the year of 2024. Your inventory records start on 1st January 2024, and end on 31st December 2024. Let’s say your company’s inventory and purchase data is as follows:
- Starting inventory (i.e., inventory you have on the 1st of Jan): £70,000
- Purchases (i.e., purchases made from 1st January to 31st December): £15,000
- Ending inventory (i.e., inventory leftover on 31st December): £10,000
Your cost of goods sold for the year 2025 is thus: 70,000 + 15,000 - 10,000 = £75,000
2. Example 2: Calculating COGS for a services company
Let’s consider a services company now, like a consulting firm. In this case, their cost of goods sold is mainly labour—either salaries they pay to employees or subcontractor fees. The firm won’t technically have inventory, except for “work in progress” labour—i.e., work at the end of a cycle that isn’t yet complete or invoiceable.
This means the COGS formula may become:
COGS (or cost of sales) = Cost of Labour Across Projects (Complete or Incomplete) - Cost of Labour on Unsold Projects
Now, let’s calculate the consulting firm’s cost of sales/COGS for the first quarter of 2025. Let’s assume the cost of labour across projects is £5,000, and that the consulting firm spent around £1,000 on projects that weren’t closed during this quarter.
The COGS is thus: £5,000 - £1,000 = £4,000
How and where is the COGS metric used?
Businesses use the COGS formula for various purposes, such as working out how much profit they can make from their core offerings or determining taxable income. Here are x ways COGS is used.
1. Calculating gross profit
A company’s gross profit is the amount of revenue it has left over after subtracting its cost of goods sold—meaning it shows how much money the business is pulling in. Another way of looking at gross profit is the amount left over for operating and non-operating expenses (like taxes or interest), which is helpful for future planning.
The formula for gross profit using the cost of goods sold is:
Gross Profit = Revenue - COGS
You can further calculate your gross profit margin by dividing the gross profit by the revenue. The gross profit margin is more commonly used as a measure of profit.
2. Working out taxable income
Expenses included in your cost of goods sold are usually tax deductible, meaning your COGS directly impacts your taxable income. A higher COGS generally means a lower taxable income because you’ve got more tax-deductible expenses.
Thus, accurately recording your COGS is important for working out how much you owe in taxable income.
3. Tracking efficiency and profitability
Tracking COGS over time helps businesses gauge efficiency and make decisions around improving profitability. COGS directly impacts gross profits, so if it increases in a specific period, it’s important to figure out why. Did the cost of your raw materials rise, or are you spending more because of inefficiencies?
Monitoring where costs are rising also helps management make decisions to improve profitability and then gauge the impact of these decisions by tracking changes in COGS. For example, if they improve the efficiency of a process or renegotiate supplier contracts, they can measure the impact in the next business cycle.
4. Determining pricing
A company’s cost of goods sold provides a baseline of how much it takes to produce its offering. Your pricing strategy needs to account for these costs, alongside other expenses like operating expenditures and your sales volumes.
5. Making product-related decisions
Since your COGS reveals the direct costs of producing a product, you can use it to compare costs between different products, identifying which ones are the most and least expensive to produce. Then, you can factor in sales volumes and profit margins to help decide which products to keep producing and which ones you might be better without.
Summary: Cost of goods sold
A company’s cost of goods sold (COGS) is usually listed on its income statement as the second entry after sales revenue. You can also calculate the COGS by adding up the starting inventory and any purchases made during a specified period (e.g., quarterly or yearly), and subtracting the leftover inventory from your result.
You can calculate a company’s COGS ratio by dividing its COGS by its total sales revenue for the specified cycle, and multiplying the result by 100. The resulting percentage is a useful indicator of a company’s profitability and growth potential, because it shows how much of the generated sales revenue is being used to cover direct production costs.
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