COGS (cost of goods sold) represents the direct costs attributable to producing or delivering the goods and services a company sells. It includes materials, direct labour, and production overheads, but excludes indirect costs like sales and administrative expenses. COGS is deducted from revenue to calculate gross profit.
Formula
COGS = Opening Inventory + Purchases - Closing Inventory (for product businesses)In Depth
Cost of goods sold is the bridge between revenue and gross profit, and understanding its composition is critical for FP&A teams managing product and service profitability.
For manufacturing businesses, COGS includes raw materials, direct labour on the production line, factory overheads, and depreciation of manufacturing equipment. For retail businesses, it is primarily the purchase cost of inventory sold. For SaaS companies, COGS — sometimes called cost of revenue — typically includes hosting and infrastructure costs, customer support team costs, payment processing fees, and third-party software licences embedded in the product.
The classification of costs as COGS versus operating expenses significantly impacts gross margin, a key metric watched by investors and analysts. FP&A teams should establish clear, consistent policies for what falls into COGS and apply them uniformly across periods.
COGS can be modelled as a fixed amount, a percentage of revenue, or through a detailed cost build-up. The right approach depends on the business model. A SaaS company might model hosting costs as a percentage of revenue that decreases at scale (reflecting infrastructure economies), while direct support costs might be driven by customer count.
For UK businesses, COGS treatment under FRS 102 and IFRS can differ in areas like inventory valuation methods (FIFO, weighted average), treatment of production overheads, and capitalisation of borrowing costs. The standard chosen affects both COGS and, consequently, reported gross margins.
Real-World Example
A UK direct-to-consumer brand reports £2.4M in revenue and £960K in COGS, yielding a 60% gross margin. The FP&A team breaks COGS down: £620K in product costs (raw materials and manufacturing), £180K in fulfilment and shipping, £100K in payment processing fees, and £60K in packaging. This granularity reveals that shipping costs have risen from 6% to 7.5% of revenue, prompting a review of carrier contracts.
Related Terms
Revenue is the total income generated from the sale of goods or services before any expenses are ded...
Gross margin is the percentage of revenue remaining after deducting the cost of goods sold (COGS). E...
Gross profit is the absolute amount of profit remaining after deducting the cost of goods sold (COGS...
Operating expenses (OpEx) are the ongoing costs incurred in running a business's day-to-day operatio...
Contribution margin is the amount remaining from revenue after deducting variable costs. It represen...
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