Understanding Cost of Goods Sold: What It Is, How to Calculate It, and Why It Matters

Written by Nicole Evans, Grand Forks Center Director

Running a small business means keeping a close eye on your numbers. One of the most important figures to understand is Cost of Goods Sold, commonly referred to as COGS. Whether you sell physical products, food, or certain services, COGS plays a key role in determining profitability and guiding informed business decisions.

Understanding COGS is more than an accounting exercise. Tracking it regularly can help you price products more effectively, control expenses, improve cash flow, and build a more profitable and sustainable business. It also provides valuable insight into the financial health of your business.

COGS is reported on the income statement and affects the calculation of taxable business income. Accurately tracking these costs supports reliable financial reporting and can help prevent issues during tax preparation.

What Is Cost of Goods Sold (COGS)?

Cost of Goods Sold refers to the direct costs associated with producing or purchasing the products a business sells. In simple terms, it represents what it costs to prepare a product for sale.

Depending on the business, COGS may include:

• Raw materials or inventory purchased for resale
• Direct labor from employees involved in production
• Manufacturing or production costs
• Freight or shipping costs directly associated with obtaining inventory

COGS generally does not include indirect operating expenses such as:

• Marketing and advertising
• Office rent and utilities
• Administrative salaries
• General business expenses

Think of it this way: if you sell a product for $50 and it costs $20 to make or purchase that product, the COGS associated with the sale is $20.

How to Calculate COGS

The basic formula is:

COGS = Beginning Inventory + Purchases − Ending Inventory

Beginning inventory is the value of inventory available at the start of the reporting period. Purchases include additional inventory acquired during that period. Ending inventory is the value of inventory that remains unsold at the end of the period.

For example:

• Beginning inventory: $10,000
• Purchases: $5,000
• Ending inventory: $7,000

Using the formula:

COGS = $10,000 + $5,000 − $7,000 = $8,000

This means the business spent $8,000 to produce or acquire the goods sold during that period.

Understanding Your COGS Percentage

Calculating COGS as a percentage of revenue helps you understand how much of each sales dollar is being spent on the products you sell.

The formula is:

COGS percentage = (COGS ÷ Revenue) × 100

For example:

• COGS: $11,000
• Revenue: $20,000

In this example, the COGS percentage is 55%. This means 55 cents of every dollar in sales revenue goes toward the direct cost of the products sold.

Monitoring this percentage over time can help identify changes in material costs, supplier pricing, production efficiency, or other factors affecting profitability.

Why COGS Matters for Small Businesses

COGS directly affects your bottom line because it is used to calculate gross profit:

Gross profit = Revenue − COGS

When COGS increases without a corresponding increase in prices or sales, gross profit decreases. This can happen even when overall sales appear strong.

Accurate COGS information also helps business owners set appropriate prices. Without understanding the full cost of producing or purchasing a product, a business may unintentionally underprice its offerings and lose money on each sale.

Tracking COGS over time can reveal opportunities for improvement, including rising material costs, inefficient production processes, inventory loss, or supplier challenges. Identifying these trends allows business owners to adjust pricing, negotiate with vendors, improve processes, or explore alternative suppliers.

Managing COGS also supports stronger cash flow. Inventory represents money invested in products that have not yet been sold. Monitoring inventory and related costs can help a business avoid overstocking, reduce waste, and keep cash moving more effectively.

Understanding Cost of Goods Sold gives business owners a clearer view of profitability and provides useful information for pricing, budgeting, inventory management, and long-term planning.

For assistance in understanding your financial statements, improving your pricing strategy, or managing costs, connect with the North Dakota Small Business Development Centers. ND SBDC advisors provide no-cost, confidential guidance to help small business owners and entrepreneurs make informed decisions and grow their businesses. Visit ndsbdc.org to connect with an advisor.