Cost of Goods Sold: What Is COGS and What’s Included?
A healthy top line is only half the profitability story. Whether you assemble electronics in Shenzhen, roast coffee in São Paulo, or manage a growing e‑commerce brand out of Berlin, you need to know exactly how much it costs to turn raw inputs into finished orders. Accountants capture that figure in a single line on the income statement – Cost of Goods Sold (COGS) – yet the number itself is the product of dozens of day‑to‑day choices in procurement, production, and freight. Understanding how COGS works, what belongs in it, and how to manage the drivers behind it can tighten margins, support accurate pricing, and ward off unpleasant tax surprises.
Below you’ll find an expanded exploration of COGS: its definition and purpose, the expenses that flow into it, the ones that must stay out, and the logistical levers you can pull to keep the figure under control. You will also see why companies with international supply chains increasingly rely on digital freight forwarders such as Unicargo to highlight – and ultimately reduce – their real, all‑in landed costs.
Understanding COGS: Definition and Purpose
In plain language, Cost of Goods Sold represents every direct expense you incur to produce – or to purchase and prepare – each unit you sell within a given accounting period. Because the figure is confined to costs that attach squarely to the goods themselves, it sits directly beneath revenue on the income statement. The difference between those two lines is gross profit, a critical measure of how efficiently your core offering converts inputs into economic value.
The role of COGS extends beyond simple arithmetic. First, it is the starting point for credible pricing. A business that cannot trace its per‑unit cost with confidence is flying blind when it sets price lists or negotiates long‑term contracts. Second, COGS is tax‑deductible in most jurisdictions, so an accurate number safeguards against over‑payment and shields you from penalties for under‑payment. Finally, tracking COGS over time reveals operational efficiency – a sudden uptick relative to sales often flags issues in sourcing, manufacturing, or inbound freight that merit investigation.
What Expenses Belong in COGS?
Although the precise composition of COGS varies by industry, the common thread is directness. The cost must be clearly and unambiguously traceable to the units that left your warehouse during the period.
Raw materials and components are the most obvious example. A furniture maker’s planks, screws, and varnish all qualify because you literally cannot ship a table without them. The same logic applies to a software firm that sells licensed hardware: the chips soldered onto each board and the plastic housing that encloses them are direct.
Direct labor follows closely behind. Wages, overtime, payroll taxes, and benefits for employees who physically build, assemble, or otherwise transform raw inputs into saleable goods belong in COGS. In a service business the equivalent may be billable consultant hours; if the client is purchasing the consultant’s time as the deliverable, that time is direct.
Freight‑in and inbound logistics also count. Moving parts from a supplier in Shenzhen to your distribution center in Rotterdam is a prerequisite for putting those parts on a customer’s order. Maritime freight, drayage from port to warehouse, import duties, customs‑brokerage fees, and even the first month of storage, if necessary before the product is available for sale, all meet the “necessary to get goods into a saleable condition” test that accountants rely on.
Packaging and allocable production overhead round out the list. If you ship each unit in a printed box, the cost of that box goes to COGS. Overhead such as machine depreciation, factory electricity, and quality‑control inspections is apportioned across the units produced. The guiding principle is reasonableness: allocate only the share of overhead that truly supports the finished goods you sold that period.
Freight and Logistics in More Detail
Inbound logistics deserves special attention because global trade has made it a substantial slice of many companies’ cost base. The key distinction is between freight‑in and freight‑out. Freight‑in covers the trip from supplier to your warehouse; freight‑out covers the journey from your warehouse to the final customer. Only the former enters COGS. The latter is properly classified as a selling expense because it occurs after the goods are ready for sale and serves to fulfill an order rather than create inventory.
Warehousing costs occupy a gray area. Storage incurred before the inventory is ready for sale – for example, if customs delays hold goods at the port – still counts toward COGS. Long‑term storage of finished goods, however, is usually treated as a period expense unless you can justify that it forms part of the product’s standard route to market. Clarifying these boundaries is one reason finance teams appreciate granular landed‑cost reports, which break down freight, duties, and handling by SKU so each cent finds its proper accounting home.
What Expenses Must Stay Out of COGS?
Equally important is understanding what doesn’t qualify. Sales and marketing expenses sit at the top of that list. Advertising campaigns, trade‑show booths, and sales‑team commissions help you win customers but do not create the product itself, so they belong under selling expenses.
Administrative overhead is another exclusion. The salaries of HR staff, the legal department, or the executive suite enable the organization as a whole rather than specific units sold. Office rent and software subscriptions that serve the entire company fall into the same bucket.
Finally, remember that freight‑out – the transportation that delivers a completed order to the end customer – never enters COGS. It is recorded among selling expenses because it occurs after revenue has been recognized and because a different accounting principle, matching, dictates that you record it in the same period as the associated revenue.
Keeping these items out of COGS guards against inflated gross margins and shields you from tax authorities who frequently audit reclassifications between direct and indirect costs.
How to Calculate COGS in Practice
Despite the conceptual complexity, the arithmetic boils down to a tidy formula:
COGS = Beginning Inventory + Purchases During the Period − Ending Inventory
Where:
- Beginning Inventory: The value of inventory at the start of the period
- Purchases During the Period: The cost of inventory acquired or produced during the period (including direct materials, direct labor, and other direct production costs)
- Ending Inventory: The value of inventory remaining at the end of the period
Suppose a retailer opens the quarter with €500,000 of inventory carried over from the prior period, purchases a further €1.2 million of product, and counts €400,000 of unsold inventory at quarter‑end. According to the formula, quarterly COGS is €500,000 + €1,200,000 – €400,000 = €1,300,000.
Manufacturers add a layer of complexity because they must incorporate work‑in‑process (WIP) inventory as well as finished goods. Direct labor and manufacturing overhead are appended to raw‑material purchases to arrive at the cost of goods manufactured, which then feeds the same opening‑plus‑purchases‑minus‑closing calculation.
Inventory Valuation Methods and Their Impact
How you assign value to inventory as it enters and leaves the system changes the COGS figure, even if physical stock levels remain constant:
- FIFO (First In, First Out) assumes the earliest units in stock are sold first. During periods of rising input prices, FIFO yields a lower COGS and therefore a higher gross profit because older, cheaper units flow through the income statement.
- LIFO (Last In, First Out) reverses the assumption, expensing the most recently acquired (and presumably more expensive) items first. LIFO raises COGS and can lower taxable income, but it is restricted to U.S. GAAP and is banned under IFRS.
- Weighted average cost smooths price volatility by dividing the total cost of goods available for sale by total units and assigning that average to each unit sold.
- Specific identification tracks the exact purchase price of individual items – appropriate for high‑value goods like diamonds or custom machinery.
Once you select a method you should apply it consistently. Frequent switches undermine comparability and can trigger audit queries.
The Relationship between Inventory Practices and COGS
Inventory is both an asset on the balance sheet and the raw material of COGS. Holding too much inventory locks up cash and eventually raises COGS when those goods are finally sold because the carrying costs – insurance, shrinkage, and obsolescence – accumulate in the meantime. Holding too little increases the risk of stock‑outs and emergency replenishment at premium freight rates, which also inflate COGS.
Inventory turnover, calculated as COGS divided by average inventory, is a handy gauge. A rising turnover ratio implies you are selling through stock more quickly and converting it to cash. Modern, cloud‑based inventory‑management systems that integrate directly with freight‑forwarding platforms such as Unicargo’s can push real‑time stock and in‑transit data into your ERP. That visibility helps planners time purchases precisely, trim safety stock, and keep COGS on an even keel.
COGS and Operating Expenses: Similar Aim, Different Scope
Both COGS and operating expenses reduce taxable income, but they hit different parts of the income statement and tell different stories. COGS reports the cost embedded in the goods sold; operating expenses capture the indirect costs of running the enterprise, from marketing to IT support.
Because investors often view gross margin (revenue minus COGS) as a cleaner indicator of a product’s intrinsic profitability, management teams sometimes feel tempted to shift borderline costs out of COGS. Regulators know this and review classifications carefully. Maintaining transparent, auditable allocations protects your reputation, and the discipline pays off when you need to raise capital or value the company.
Using COGS Strategically
A trustworthy COGS figure can also be viewed as a strategic asset. When you can trace landed cost to the SKU level you gain confidence to raise or reduce prices, negotiate supplier terms, and design promotions without guessing at margin impact.
COGS also informs your make‑or‑buy decisions. If a contract manufacturer quotes you a build cost only slightly below your in‑house cost, but your numbers include significant freight‑in (because you import raw materials), you might decide the better margin lies in outsourcing production closer to your end market. Conversely, if the quoted price leaves little room for logistics inflation, staying in‑house could be wiser.
Unicargo clients often model alternative freight scenarios, and they can ask, for example, what happens to COGS if they shift half their shipments from air to expedited ocean service or consolidate small parcel imports into weekly less‑than‑container‑load (LCL) lots. Seeing the ripple effects in dollars and days allows supply‑chain managers and CFOs to speak the same language.
Recognising the Limitations of COGS
No metric is perfect. COGS does not capture every nuance of operational performance. Two plants may report identical COGS yet differ drastically in on‑time delivery or carbon emissions. Service businesses that bundle labour, software, and physical deliverables often struggle to separate direct from indirect cost cleanly, making inter‑company comparisons tricky.
Moreover, COGS accuracy depends on inventory accuracy. A faulty cycle count, an unrecorded vendor rebate, or mis‑applied freight charge can distort the number for months before a physical audit corrects it. That is why forward‑looking companies pair COGS with complementary indicators such as contribution margin, cash‑to‑cash cycle time, and on‑time‑in‑full fulfillment.
Unicargo Case Study
One of Unicargo’s clients in the electronics sector, a fast-growing e-commerce retailer importing critical components from multiple suppliers in Shenzhen, was struggling with ballooning logistics costs and hidden freight fees. After integrating Unicargo’s digital freight-forwarding platform, they consolidated less-than-container-load shipments, gained real-time, SKU-level visibility into landed costs, and automated customs clearance workflows. In just six months, this client slashed their Cost of Goods Sold by 18 percent – thanks to streamlined freight, fewer customs delays, and sharper inventory insights – ultimately boosting both their profitability and operational agility.
Conclusion: Turning COGS Mastery into Competitive Advantage
When you understand what truly drives COGS, you can shape it rather than merely record it. Thorough landed‑cost data clarifies margin at the point where it is earned, revealing opportunities to negotiate better component pricing, choose more efficient freight modes, and fine‑tune inventory levels. Every incremental improvement flows straight to gross profit and strengthens your balance sheet.
Given the outsized role that freight, warehousing, and customs duties play in global supply chains, businesses that enlist a data‑driven logistics partner gain a measurable edge. Unicargo’s digital ecosystem unifies booking, real‑time tracking, automated customs clearance, and inventory analytics so finance and operations teams see the same numbers in the same dashboard. With that shared truth they can collaborate on initiatives – from mode shifting to origin consolidation – designed specifically to lower COGS without sacrificing service.
If your organisation is ready to put granular cost visibility to work, we invite you to speak with a Unicargo expert and discover how precision logistics can translate to healthier margins and sustainable growth.
FAQ: Cost of Goods Sold (COGS)
- What is Cost of Goods Sold (COGS)? Cost of Goods Sold represents the total direct costs a company incurs to produce the goods it sells during a specific period. It includes raw materials, direct labor, and manufacturing overhead directly tied to production.
- Which expenses are included in COGS? COGS comprises the cost of direct materials, direct labor, manufacturing overhead (for example, factory utilities and equipment depreciation), and freight-in charges for bringing materials to the production site. It excludes sales, marketing, and administrative expenses.
- What is not included in COGS? Operating and selling expenses – such as sales and marketing costs, administrative salaries, office rent, and freight-out (shipping finished goods to customers) – are not part of COGS.
- How is COGS calculated? Use this formula:
COGS = Beginning Inventory + Purchases During the Period − Ending Inventory
This ensures that only the cost of goods actually sold is reflected on the income statement.
- Why is COGS important for businesses? COGS directly affects gross profit, informs accurate pricing, and supports effective inventory management. Because it is tax-deductible, precise COGS reporting is also essential for compliance and meaningful financial analysis.
- How do inventory valuation methods affect COGS? Different methods – FIFO (First In, First Out), LIFO (Last In, First Out), and weighted average cost – can yield different COGS amounts even when inventory levels remain unchanged. Your choice of method influences reported profits and tax liabilities, so consistency is crucial.
Disclaimer: The information provided in this article is for general guidance only and does not constitute financial, accounting, or tax advice. Always consult qualified professionals regarding your specific circumstances.
