Understanding COGS: Cost of Goods Sold for Service & Product Businesses

What Is Cost of Goods Sold?

Cost of goods sold (COGS) represents the direct costs of producing or delivering the goods and services you sell. It is the cost directly attributable to generating your revenue - not overhead, not administration, not marketing, but the actual cost of what you sold.

For a product business, COGS includes materials, manufacturing labour, and packaging. For a service business, it includes the direct labour and materials used to deliver the service.

COGS matters because it determines your gross profit - the money left after direct costs, which must cover all your overheads and generate a net profit.

Gross Profit = Revenue - COGS

Gross Margin = Gross Profit / Revenue x 100

COGS for Product Businesses

For businesses that sell physical products, COGS typically includes:

Materials and Components

The raw materials or components that go into your product. For a furniture maker, this is timber, fabric, screws, and glue. For a retailer, this is the wholesale cost of the products you resell.

Manufacturing Labour

The wages of people directly involved in making the product. This includes assembly workers, machinists, and quality checkers. It does not include sales staff, admin, or management.

Shipping and Freight (Inbound)

The cost of getting materials to your workshop or products to your warehouse. Outbound shipping (to customers) is sometimes included in COGS and sometimes treated as a separate expense - be consistent.

Packaging

Materials used to package your product for sale - boxes, labels, bags, tape.

The COGS Formula for Product Businesses

COGS = Opening Inventory + Purchases - Closing Inventory

This formula accounts for the fact that you may buy inventory in one period but sell it in another.

Example:

• Opening inventory: $20,000
• Purchases during the period: $45,000
• Closing inventory: $18,000
• COGS: $20,000 + $45,000 - $18,000 = $47,000

If revenue was $120,000, gross profit is $73,000 and gross margin is 60.8%.

COGS for Service Businesses

Service businesses often overlook COGS, treating all expenses as overhead. This is a mistake. Service businesses have direct costs too:

Direct Labour

The wages (including super and on-costs) of people who directly deliver the service. For a consulting firm, this is the consultant's time. For a cleaning business, this is the cleaner's time. For a law firm, this is the lawyer's billable time.

Include only the time spent delivering client work. Administrative time, training, and non-billable activities are overhead, not COGS.

Direct Materials

Materials consumed in delivering the service. For a cleaning business, this is cleaning supplies. For a hairdresser, this is colour and treatment products. For a mechanic, this is parts and consumables.

Subcontractor Costs

If you engage subcontractors to deliver client work, their cost is part of your COGS. A marketing agency that hires freelance designers for client projects includes those freelancer costs in COGS.

What Is NOT COGS for Service Businesses

• Office rent
• Administrative salaries
• Marketing and advertising
• Insurance
• Software subscriptions (unless directly used for a specific client)
• Vehicle costs (unless directly related to client delivery)

These are overhead expenses, not COGS.

Why COGS Matters

Pricing

You cannot price correctly without understanding COGS. If your COGS is 60% of revenue, your gross margin is 40%. If your overhead is 35% of revenue, your net margin is only 5%. Knowing this tells you whether you need to raise prices, reduce direct costs, or cut overhead.

Profitability by Product or Service

When you track COGS per product or service line, you can identify which offerings are most profitable and which are dragging down your margins.

Example: A graphic design agency offers three services:

• Logo design: Revenue $2,000, COGS $600, Gross margin 70%
• Website design: Revenue $8,000, COGS $5,500, Gross margin 31%
• Social media management: Revenue $1,500/month, COGS $300/month, Gross margin 80%

This reveals that website design has the lowest margin and may need repricing or process improvement.

Business Valuation

Buyers and investors look at gross margin as an indicator of business health. A business with a 60% gross margin is more attractive than one with a 25% gross margin, all else being equal.

Benchmarking

Comparing your COGS and gross margin to industry benchmarks tells you whether your costs are competitive:

• Retail: COGS typically 50-70% of revenue (gross margin 30-50%)
• Professional services: COGS typically 30-50% (gross margin 50-70%)
• Construction: COGS typically 65-80% (gross margin 20-35%)
• Hospitality: COGS (food and beverage) typically 25-35%

Setting Up COGS in Your Accounting Software

In Xero and QuickBooks, set up a "Cost of Sales" (or "Cost of Goods Sold") section in your chart of accounts, separate from operating expenses:

• Direct materials
• Direct labour
• Subcontractors
• Freight and shipping
• Packaging

When you code expenses, put direct costs in the COGS accounts and overheads in the operating expense accounts. This separation is essential for accurate gross profit reporting.

SortBooks can be configured to correctly categorise direct costs versus overheads, ensuring your gross margin calculations are reliable.

Tracking COGS Over Time

Monitor your COGS monthly as both a dollar amount and a percentage of revenue:

• Is the percentage stable? Good - your direct costs are scaling proportionally with revenue.
• Is the percentage increasing? Problem - your direct costs are growing faster than revenue. Investigate why.
• Is the percentage decreasing? Excellent - you are becoming more efficient.

Track COGS by product or service line quarterly. This level of detail reveals profitability issues that top-line numbers hide.

Common Mistakes

Putting everything in COGS - Only direct costs belong in COGS. Office rent is not a direct cost of delivering your product.

Ignoring COGS entirely - Some businesses code all expenses to a single "Expenses" account. This makes it impossible to calculate gross margin.

Inconsistent treatment - Code the same type of expense to the same account every time. Inconsistency produces unreliable reports.

Not tracking inventory - Product businesses that do not count inventory cannot calculate accurate COGS.

Understanding COGS is fundamental to understanding your business's profitability. Get it right, track it consistently, and it becomes one of your most powerful management tools.