Cost of Goods Sold Explained for Small Business

What belongs in COGS

For a product business, COGS includes the purchase cost of inventory sold, freight in, and direct production labor and materials if you manufacture. Packaging that goes with each sale often counts too. For a service business, COGS may include subcontractors and materials used directly on jobs.

It does not include general overhead like rent for an office, marketing, or administrative salaries. Those are operating expenses.

The basic formula

For inventory businesses: beginning inventory plus purchases during the period, minus ending inventory, equals COGS. If you started with a certain stock, bought more, and counted what remains, the difference is what was sold at cost.

This is why accurate inventory counts matter. An error in ending inventory flows directly into COGS and profit.

Perpetual or periodic

A perpetual system updates inventory with each sale and purchase, so COGS is recorded at the time of sale. A periodic system waits until the end of the period, then uses the formula. Many small businesses start periodic and move to perpetual as software helps.

Whichever you use, reconcile your records with physical counts.

Common mistakes

Putting inventory purchases straight to expense, so COGS is overstated in the buying month, is a common one. Another is leaving freight and duties out. A third is misclassifying a direct cost as overhead, which makes gross margin look better than it is.

If you sell services, decide which costs rise and fall with jobs, and keep that classification stable.

Why it matters

Gross margin depends on COGS. Watching it by product or service line shows what is truly profitable. It is also part of your tax return, so inventory methods and counts need support.

Review COGS as a percent of sales every month. A rising percentage may signal supplier price increases, waste, theft or discounting. Share your method and counts with your tax preparer, since different rules apply to certain small businesses, and your CPA can confirm what you must use.

A quick example

A shop starts the quarter with stock valued at a set amount, buys more during the quarter, and counts what is left at the end. Add the beginning stock to purchases, subtract the ending count, and the result is COGS. If sales were higher than that figure by a healthy margin, the shop is covering its direct costs. If the margin is thin, the owner can test price changes, supplier quotes or packaging costs before overhead gets involved.

If your COGS percentage moves, drill into the pieces: purchases, freight, labor and inventory change. One piece usually explains most of the movement. Documenting the explanation each month builds a record that helps with pricing and with year-end tax work.

Check your work (with numbers)

Say you start the quarter with $8,000 of inventory, buy $14,500 more during the quarter and count $9,300 on hand at the end. Cost of goods sold is $8,000 + $14,500 - $9,300 = $13,200. If your books show COGS of $14,500 (purchases only), profit is understated by $1,300 because you never subtracted the growth in inventory.

Then test the margin. If sales were $31,000, gross profit is $31,000 - $13,200 = $17,800, or about 57.4%. Compare that percentage to prior quarters. A sudden drop usually means unrecorded purchases, a counting error, shrinkage, or prices that did not keep up with costs.

Finally, tie the ending inventory to the physical count sheet and the balance sheet line. If those three numbers differ, fix that before trusting any margin.

Common questions

This guide is general information, not tax, legal or accounting advice. Rules, fees and due dates change; check with the IRS, the NJ Division of Taxation or a licensed professional for your situation.