The cost of goods sold (COGS) is the total cost a business incurs to produce or purchase the products it sells during a specific period. This includes all expenses directly tied to making or buying the items your business sells: raw materials, labour costs, and direct manufacturing overhead.

COGS is key in calculating your gross profit: the lower your COGS, the more profit you keep. Below, we’ll explain what businesses should know about calculating COGS, what’s included in this figure, and how businesses can use it to make important decisions.

What’s in this article?

• Why is COGS important for accounting?
  
• What expenses are included in COGS?
  
• What is excluded from COGS?
  
• How do you calculate COGS?
  
• How does inventory valuation affect your COGS?
  
• How can Stripe help businesses manage COGS processes?
  
• How does COGS affect taxes?
  

Why is COGS important for accounting?

COGS is an important part of accounting that affects a business’s profitability and financial health. Here’s how it works:

• Calculating gross profit: Gross profit is determined by subtracting your COGS from your revenue. Without an accurate view of your COGS, you can’t reliably know how much money you’ll have after covering your own costs or purchasing inventory.

• Managing taxes: COGS is a deductible expense, which reduces your taxable income. Accurately calculating COGS helps prevent you from overpaying or under-reporting on your taxes, both of which can lead to serious consequences.

• Setting pricing strategy: Knowing your COGS helps you set prices more effectively. If your COGS is high relative to your sales price, your margins shrink, or you might be losing money. Understanding these numbers helps you keep pricing competitive while still covering your own costs.

• Managing inventory: COGS and inventory are deeply connected. COGS reflects whether a business is overstocking, understocking, or wasting resources. Tracking it lets businesses identify inefficiencies and eliminate them.

• Planning: Businesses use COGS to forecast expenses, make budgeting decisions, and assess whether it’s viable to expand operations.

What expenses are included in COGS?

Only expenses that are directly related to producing or purchasing the goods a business sells are included in COGS. Here’s what is typically included:

• Raw materials: These are the costs of any materials used to produce a product.

• Direct labour: These are the wages for employees directly involved in production (e.g. factory workers assembling a product).

• Direct production overheads: These are the direct costs you incur in production. Examples include a factory’s utilities, such as electricity and water, and storage for inventory.

• Shipping or freight costs: These are the costs of shipping raw materials or products for resale to your facilities.

• Costs of finished goods (for retailers/wholesalers): This is the purchase price of goods for resale.

What is excluded from COGS?

Certain costs are excluded from COGS because they aren’t directly tied to producing or acquiring the goods you sell. As a shortcut, excluded expenses usually fall under operating expenses or selling, general, and administrative (SG&A) costs on your income statement. Here are the types of items that normally do not count toward your COGS:

Administrative costs

• Salaries for office staff (e.g. HR, accounting, administrative employees)

• Office supplies not used in production

Marketing expenses

• Advertising campaigns

• Sales team salaries and commission

• Promotional materials and trade shows

General business overhead

• Rent or lease payments for corporate offices

• Utilities unrelated to production (e.g. electricity bills for the office)

• Depreciation of office equipment, such as computers, printers, or furniture

Distribution costs

• Shipping or delivering finished goods to customers
  

Research and development (R&D)

• Costs associated with developing new products or improving existing ones

• Costs for prototyping and user testing

Other indirect expenses

• Insurance policies that are not specifically related to manufacturing or production

• Interest on business loans

• Legal and consulting fees

How do you calculate COGS?

The formula to calculate COGS is:

COGS = Beginning Inventory + Purchases During the Period - Ending Inventory

To calculate COGS, first determine your starting inventory. This is the value of the inventory you had on hand at the start of the accounting period, which you can find on the previous period’s balance sheet.

Next, add up purchases during the period. Include all costs for acquiring inventory for sale, such as raw materials, freight or shipping costs, and any additional costs directly tied to getting products ready for sale.

At the end of the period, calculate the value of inventory still on hand with a physical count or inventory management software. Subtract this number from your beginning inventory and purchases to determine your COGS.

Sample calculation

• Beginning Inventory: £20,000

• Purchases During the Period: £50,000

• Ending Inventory: £15,000

COGS = £20,000 + £50,000 - £15,000 = £55,000

How does inventory valuation affect your COGS?

When you calculate COGS, you subtract your ending inventory from your total goods available for sale. But finding your ending inventory valuation depends on the method you use. Here are three widely used methods for inventory valuation:

LIFO

Last In, First Out (LIFO) assumes you sell your newest inventory first. When prices rise, LIFO drives COGS higher because the most recent, higher-cost items are sold first. This lowers net profit but can reduce taxable income.

LIFO is used as a tax strategy in markets with consistent cost increases. It’s not allowed under the International Financial Reporting Standards (IFRS), so it’s used only in the US and Japan. An estimated 15% of US businesses in the S&P 500 use the LIFO method.

FIFO

First In, First Out (FIFO) assumes the oldest inventory is sold first. As costs rise, FIFO valuation lowers your COGS because the cheaper, older inventory is “used up” first. Your net profit will also rise, but you’ll be left with higher-value inventory on the balance sheet.

Though FIFO is a better reflection of inventory value on the balance sheet, it’s a less tax-friendly valuation method.

WAC

Weighted average cost (WAC) averages inventory costs over time. This method accounts for price fluctuations to moderate COGS and profits. It’s ideal for businesses that can’t easily track the cost of individual inventory items.

The way you value your inventory directly affects your COGS figure, your profit calculations, and how healthy your business appears. For example, FIFO can make profits look stronger during inflation but might not reflect the true cost of replacing inventory. Your choice of inventory valuation method reflects your business priorities, whether that’s keeping your tax bill low, maximising your reported profit, or managing costs. When you choose a valuation method, you should stay consistent: switching methods without offering clear justification can be a red flag for auditors or investors.

How can Stripe help businesses manage COGS processes?

Though Stripe doesn’t directly calculate COGS, it helps businesses manage the processes closely related to COGS, such as paying for raw materials, tracking sales, and maintaining relationships with suppliers. Here’s how Stripe can help your business:

• Real-time revenue tracking: Stripe provides detailed insights into your sales data. By tracking trends in real time, businesses can better manage their inventory and production schedules and gain a clearer understanding of how their revenue is informed by COGS.

• Automated payments: Stripe’s automated payouts make it easier to pay suppliers and vendors. With tools such as Stripe Connect, businesses can set up workflows to handle recurring payments. This improves supplier relationships and ensures a steady flow of resources for production.

• Inventory integrations: Stripe can integrate with your accounting and inventory software, such as QuickBooks, Xero, and NetSuite. You can sync your data to compare inventory and production costs against sales and more accurately calculate COGS.

• Billing management: Stripe Billing automates invoicing for businesses with recurring billing-based subscription models or consumption-based models (e.g. software, memberships, per-use goods). Your business can better capture all sales and production-related costs with accurate, on-time invoicing.

• Global sales support: Stripe supports international payments and can help businesses manage revenue and costs in multiple currencies. Stripe simplifies international payments and currency conversion for businesses with global vendors or clients.

• Analytics for pricing strategy: Stripe’s analytics tools provide deep insights into customers’ purchasing behaviour. This helps businesses price their products more competitively against their costs and identify emerging trends on high-margin items to inform production and inventory strategies.

• Fraud prevention to protect your margins: Fraudulent transactions increase your operating costs and chip away at your margins. Stripe’s fraud prevention tools help minimise these risks so chargebacks or lost inventory don’t inflate your COGS.

How does COGS affect taxes?

COGS is a core business expense that’s subtracted from your revenue to calculate gross profit. It directly affects your taxable income and overall tax liability. Here’s how it breaks down:

• Gross Profit = Total Revenue - COGS

• Taxable Income = Gross Profit - Operating Expenses

The higher your COGS, the less taxable income you have, which usually means you pay less in taxes. Conversely, a lower COGS increases taxable income, which can lead to a higher tax bill. To make sure you’re deducting COGS correctly, you should:

• Meticulously track your inventory, especially your beginning and ending balances

• Include all costs directly tied to producing or acquiring goods

• Properly account for inventory that hasn’t been sold yet

Because COGS is closely tied to your business taxes, any errors or inconsistencies can attract attention from auditors or tax authorities. Overstating COGS to artificially lower your taxes is unethical and illegal. To make sure you comply with tax law, use a consistent inventory valuation method, keep detailed records of your production and purchasing costs, and keep your COGS calculations in line with generally accepted accounting principles (GAAP) or IFRS standards.