Cost of goods sold (COGS): meaning, formula, and examples

Whether you run a retail store, restaurant, café, takeaway, or another product-based business, COGS helps you understand what you're actually spending to generate sales.

Without COGS, it's difficult to know whether your pricing is working, your margins are healthy, or your business is truly profitable.

We'll explain what COGS is, what's included, how to calculate it, and why it matters for small businesses.

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Key takeaways:

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• Cost of goods sold (COGS) refers to the direct costs involved in producing or purchasing the products you sell.
• COGS is used to calculate gross profit and assess business profitability.
• Common COGS expenses include inventory, raw materials, and direct production costs.
• The basic formula is: Opening Inventory + Purchases − Closing Inventory = COGS.
• Tracking inventory accurately can help improve the accuracy of your COGS calculations.

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What is cost of goods sold (COGS)?

Cost of goods sold (COGS) is the total direct cost of the products your business sells during a specific period. In simple terms, it's what you paid for the products that generated your sales.

For a retailer, this might be the wholesale cost of products purchased from suppliers. For a restaurant, it could include ingredients used to prepare meals. And for a manufacturer, it may include raw materials and direct production costs.

COGS focuses only on costs directly related to producing or purchasing goods. It doesn’t include general business expenses such as rent, marketing, utilities, or office costs.

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Why is COGS important for small businesses?

Knowing your COGS helps you understand how profitable your sales actually are.

Many business owners focus heavily on revenue, but revenue only tells part of the story. What matters is how much of that revenue remains after covering the costs of the products sold.

COGS plays an important role in:

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Measuring profitability

COGS is used to calculate your gross profit, helping you understand how much money your business retains from sales before other operating expenses are deducted.

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Setting prices

If you don't know what your products cost, it's difficult to price them effectively. Understanding COGS helps ensure you're charging enough to maintain healthy margins.

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Managing inventory

Tracking inventory accurately makes it easier to calculate COGS and avoid unnecessary stock costs.

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Making informed decisions

Understanding product costs can help identify which items generate strong margins and which may be reducing profitability.

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What’s included in the cost of goods sold?

COGS includes the direct costs associated with producing or purchasing the goods you sell.

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Depending on your business type, here’s an overview of what this may include:

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The key principle is simple: if the cost is directly related to creating or purchasing the products you sell, it may form part of your COGS.

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What isn’t included in COGS?

Not all business expenses count towards the cost of goods sold.

Here are some examples of expenses typically excluded:

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• Rent
• Utilities
• Marketing costs
• Accounting fees
• Payment processing fees
• Office expenses
• General administrative costs

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These expenses are usually classified as operating expenses rather than COGS.

You might also be interested in: Operating profit explained: What is it, and how is it calculated?

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How to calculate cost of goods sold (COGS)

The standard formula for calculating COGS is:

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COGS = (Opening Inventory + Purchases) - Closing Inventory

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• Opening inventory:
  The value of inventory you had at the beginning of the accounting period.
• Purchases:
  The cost of additional inventory or materials purchased during the period.
• Closing inventory:
  The value of inventory remaining at the end of the period.

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The result is the total cost of the goods sold during that period.

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Cost of goods sold example

Let's say a retail business starts the month with £8,000 worth of inventory.

During the month, it purchases an additional £4,000 of stock.

At the end of the month, £3,000 worth of inventory remains unsold.

The calculation would be:

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8,000 + 4,000 = 12,000

12,000 = 3,000 = 9,000

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This means the business sold £9,000 worth of inventory during that month.

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How COGS affects profit

COGS is directly linked to profitability: once you've calculated your revenue and COGS, you can determine your gross profit.

The formula is:

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Gross Profit = Revenue - COGS

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For example:

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• Revenue: £20,000
• COGS: £9,000

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The calculation would be: 

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20,000 - 9,000 = 11,000

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So the gross profit is £11,000.

This gross profit figure is what remains before operating expenses such as rent, wages, and marketing are deducted.

That's why keeping COGS under control is an important part of improving overall profitability.

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How inventory management can help control COGS

Accurate inventory management can have a significant impact on Cost of Goods Sold.

Without clear visibility of stock levels, businesses may experience:

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• Over-ordering
• Stock shortages
• Waste
• Excess inventory
• Inaccurate reporting

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Good inventory management helps ensure stock levels remain accurate and makes calculating COGS much easier.

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Want to learn more? Check out our guide to inventory management.

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Common questions about cost of goods sold

What does COGS stand for?

COGS stands for cost of goods sold.

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What is included in the cost of goods sold?

COGS typically includes inventory purchases, raw materials, and other direct costs associated with producing or purchasing the products you sell.

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What is excluded from COGS?

Expenses such as rent, marketing, utilities, accounting fees, and general administrative costs are usually not included in COGS.

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How do you calculate COGS?

The standard formula is: Opening Inventory + Purchases − Closing Inventory = COGS

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Why is COGS important?

COGS helps businesses understand profitability, set pricing, manage inventory, and make better financial decisions.

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Is COGS the same as operating expenses?

No. COGS covers the direct costs of producing or purchasing goods, while operating expenses cover the wider costs of running the business.

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A simpler way to stay on top of your business

Understanding your cost of goods sold is an important step on the way to running a more profitable business.

The more accurately you track inventory, sales, and product performance, the easier it becomes to understand your margins and make informed decisions.

Flatpay helps you stay on top of day-to-day operations with:

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• £0 monthly fees
• 1.69% flat transaction rate
• Clear, real-time reporting
• Simple inventory tracking
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Spend less time digging through spreadsheets and more time focusing on growing your business.

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