Cost of Goods Sold Basics

Gross profit is the first number a lender, a buyer or an accountant looks at, and cost of goods sold is the number that makes it. Yet in many small business files, COGS is a dumping ground — some direct costs land there, some land in general expenses, and the margin on the reports has only a loose relationship with the margin the business actually earns.

Separating COGS from operating expenses is not accounting tidiness. It is the difference between two questions: what does it cost to make or buy the thing you sell, and what does it cost to run the business around it? Mix them together and you cannot tell whether a shrinking profit is a pricing problem or an overheads problem — and those have very different fixes.

What belongs in COGS

• The goods themselves — purchases of stock, raw materials and components.
• Getting them to you — freight inwards, import duties and customs charges on the goods you buy.
• Making them sellable — packaging that forms part of the product, and direct production labour where it can genuinely be tied to the goods.

Costs that keep the business running — rent, insurance, marketing, software subscriptions, and usually the courier cost of sending sold goods out to customers — sit in operating expenses instead. The dividing line is directness: if a cost rises and falls with the goods you sell, it usually belongs in COGS; if it exists whether or not you sell anything this month, it usually does not. Where a cost genuinely straddles the line, pick a sensible treatment and apply it consistently — consistency is what makes your margins comparable from one period to the next.

Do service businesses have COGS?

Often yes, though it is usually labelled cost of sales rather than cost of goods sold. Subcontractors on a building job, parts fitted by a mechanic, freelance designers billed through an agency — these are direct costs of delivering the work, and putting them in cost of sales shows the true margin on each job. A pure service business with no direct costs may have no COGS section at all, and that is perfectly fine. What matters is that direct delivery costs are not buried among overheads.

COGS follows the sale, not the purchase

Buying stock is not, by itself, an expense — it is swapping cash for an asset. The cost only becomes COGS when the goods are sold, which is why the calculation runs opening stock, plus purchases, minus closing stock. This is also why COGS and your stocktake are two halves of one system: without a reliable closing stock figure, the COGS number is a guess, and so is your gross margin. If you stock up heavily in one month, your profit for that month should not collapse — if it does, purchases are being expensed straight away with no stock adjustment.

What we commonly see go wrong

• Freight inwards coded to the same account as outgoing customer deliveries, so nobody can see the landed cost of the goods.
• Import duty and customs broker charges scattered across bank fees and consulting because that is where the payment lines were guessed.
• Supplier deposits expensed when paid, then the final invoice expensed again — double-counting the same goods.
• Gross margins that swing wildly month to month because purchases are expensed as they happen, with no stock adjustment at all.

A worked example

As an illustration: an importer of kitchenware codes sea freight, duty and broker fees to general expenses. The gross margin on the reports looks comfortable, so prices stay where they are. When those direct costs are moved into COGS where they belong, the true margin is visibly thinner — thin enough that a couple of underpriced product lines were quietly being subsidised by the rest of the range. Nothing about the business changed, only where the costs sat, but the pricing decision it prompted was completely different.

When to get help

If your gross margin does not match what you believe you mark up, if the reports swing in ways you cannot explain, or if you are pricing off numbers you do not quite trust, it is worth having the chart of accounts and the COGS treatment reviewed once. It is a structural fix — done properly, every report after it gets more useful.

Does my service business need a COGS section?

Only if you have direct costs of delivering the work — subcontractors, materials, parts or direct freelance labour. If you do, a cost of sales section shows your real margin on each job. A pure service business with no direct costs can legitimately have no COGS at all.

Is freight part of COGS?

Freight inwards — getting goods from your supplier to you — generally belongs in COGS, along with import duties, because it is part of the landed cost of the goods. Delivery of sold goods out to customers is usually treated as an operating expense. Whichever treatment you use for borderline costs, apply it consistently.

Why does my gross margin jump around from month to month?

The most common cause is expensing stock purchases as they are paid without any stock adjustment, so heavy buying months look unprofitable and quiet months look great. Bringing opening and closing stock into the calculation smooths this out and shows the real margin.