You're looking at your Profit and Loss statement, and there it is. Cost of Goods Sold. It sits right under your revenue, staring you in the face. Naturally, you think, "Okay, this is money going out of the business, so it’s an expense, right?"
Well, kinda.
In the world of accounting, things are rarely that straightforward. If you ask a CPA is cost of goods sold an expense, they’ll probably give you a slow nod followed by a "but." It’s one of those technicalities that seems like hair-splitting until you’re trying to secure a bank loan or figure out why your net income looks so different from your cash flow. COGS is an expense, but it’s a very specific, high-maintenance type of expense that lives in its own neighborhood on your financial reports.
The Short Answer That Everyone Wants
Yes. At its core, Cost of Goods Sold (COGS) is an operating expense. It represents the direct costs of producing the goods sold by a company. If you spend $5 to buy a widget and sell it for $10, that $5 is an expense because it’s a cost incurred to generate that revenue.
But here is the kicker: it’s not a general expense.
Business owners often lump everything together—rent, coffee for the breakroom, and the raw steel used for manufacturing. That’s a mistake. Under Generally Accepted Accounting Principles (GAAP), COGS is treated differently than your electric bill. It’s tied directly to the inventory you actually sold. If you bought 1,000 units of stock but only sold 10, your COGS only reflects those 10. The other 990 units? Those are assets. They sit on your balance sheet as inventory.
This distinction is why your tax return might look a bit weird compared to your bank balance. You’ve spent the money, but you haven't "expensed" it yet in the eyes of the IRS or the IFRS.
Why the Distinction Matters for Your Taxes
Let’s talk about the IRS. They care deeply about whether something is COGS or a business expense. Why? Because it changes your Gross Profit.
Revenue minus COGS equals your Gross Profit.
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Everything else—your marketing, your legal fees, the fancy ergonomic chairs—comes out after that. These are often called "below the line" expenses. COGS is "above the line." If you misclassify a direct cost as a general expense, you’re muddying the waters of your business's efficiency. Investors look at Gross Margin (Gross Profit divided by Revenue) to see if you actually have a viable product. If your COGS is too high, it doesn't matter how much you save on rent; the business model is fundamentally broken.
Real-world example: A local bakery.
The flour, the sugar, the yeast, and the wages for the person actually kneading the dough? That’s COGS.
The Facebook ads to get people in the door? That’s a general expense.
The difference is that the flour is physically "in" the bread. The Facebook ad is not.
What Actually Goes Into COGS?
It’s not just the price tag on the item you bought from a wholesaler. It’s more granular. Honestly, it’s where a lot of small businesses get messy.
To calculate is cost of goods sold an expense that you’re tracking accurately, you have to include:
- Raw materials: The literal stuff you use to make a product.
- Direct labor: The hours spent by people on the assembly line or the kitchen floor.
- Freight-in: The cost to get the materials to your warehouse (but not the cost to ship it to the customer—that’s usually a selling expense).
- Manufacturing overhead: This is the tricky part. It’s the electricity for the factory machines or the rent for the production facility.
If you’re a service provider, you might not even have COGS. You might have COS—Cost of Services. It’s basically the same thing, but instead of physical parts, you’re looking at the direct labor hours required to deliver a project. A law firm doesn't have "goods," but they definitely have costs directly tied to billable hours.
The Inventory Trap
Most people get tripped up by the formula. It’s a classic accounting staple:
Beginning Inventory + Purchases during the period - Ending Inventory = COGS.
Let’s say you start the year with $10,000 in inventory. You buy $50,000 more throughout the year. At the end of December, you count your shelves and realize you have $15,000 left.
$$10,000 + 50,000 - 15,000 = 45,000$$
Your COGS is $45,000.
Wait. You spent $50,000 this year on stock. Why is the expense only $45,000? Because $5,000 of what you bought is still sitting in your warehouse. It hasn't been "sold" yet, so it can't be "cost of goods sold." It stays an asset.
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Is COGS the Same as Operating Expenses?
No. And this is a hill accountants will die on.
Operating expenses (OPEX) are the costs of keeping the lights on regardless of how many sales you make. Rent, insurance, and administrative salaries are usually fixed or semi-fixed. If you sell zero products tomorrow, you still owe the landlord.
COGS is variable. If you sell zero products, your COGS should be zero.
This distinction is vital for "Break-Even Analysis." If you don't know your COGS, you don't know how many units you need to sell to cover your OPEX. I’ve seen businesses grow their revenue by 50% while their profits stayed flat because their COGS was scaling faster than their price points. They were "losing money on every sale but trying to make it up in volume," which is a fast track to bankruptcy.
The Nuance of "Direct" vs "Indirect"
Let’s get nerdy for a second. There is a gray area called "Absorption Costing."
In some cases, you have to "absorb" indirect costs into your COGS. Imagine a factory that makes shoes. The glue used for the soles is a direct material. But what about the supervisor who watches five different lines? His salary isn't tied to one specific shoe, but without him, no shoes get made.
Under certain accounting standards, a portion of that supervisor's salary must be allocated to COGS. This makes the answer to is cost of goods sold an expense even more complex. It's an expense that includes a "piece" of many different costs, all bundled into the value of the product.
Different Methods, Different Expenses
How you value your inventory changes your COGS. It’s a bit of a shell game, legally speaking.
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- FIFO (First-In, First-Out): You assume the oldest items are sold first. In an inflationary environment where prices are rising, FIFO results in a lower COGS because you’re "expensing" the cheaper, older stock first. This makes your profit look higher.
- LIFO (Last-In, First-Out): You assume the newest (and often most expensive) items are sold first. This increases your COGS and lowers your taxable income. Many countries don't allow LIFO because it’s a bit of a tax dodge, but it’s still used in the U.S.
- Average Cost: You just take the total cost of all items and average them out. It’s the "lazy" way, but it works well for businesses with thousands of small, identical items like screws or bolts.
If you switch methods, your COGS will change even if your physical sales stay exactly the same. That’s why you can’t just look at one number in a vacuum. You have to understand the logic behind the math.
Common Misconceptions That Kill Cash Flow
I’ve talked to many founders who think that because they paid for a shipment of goods, their profit dropped by that amount immediately.
That isn't how it works.
If you spend $100,000 on inventory in October for the holiday rush, your profit for October doesn't necessarily plummet. You've simply swapped one asset (cash) for another asset (inventory). You only feel the "expense" in November and December when those items leave the building.
This is why "Cash Basis" vs "Accrual Basis" accounting is such a big deal. Small businesses often use cash basis because it’s easier. But if you have significant inventory, the IRS usually requires you to use the accrual method for your COGS. They want to make sure you aren't overstating your expenses by buying a bunch of stock right before New Year’s Eve just to lower your tax bill.
Actionable Steps for Business Owners
Don't just let your bookkeeper handle this. You need to understand your margins.
- Review your chart of accounts: Make sure your "Direct Labor" isn't buried in "Payroll Expenses" alongside your receptionist’s salary. It needs to be in the COGS section.
- Do a physical count: Software is great, but it’s often wrong. Shrinkage (theft, damage, or lost items) needs to be accounted for. If you have less inventory than your computer says, your COGS actually increases because you have to "write off" those missing items as a cost of doing business.
- Analyze your Gross Margin monthly: If your revenue goes up but your Gross Margin percentage goes down, your COGS is out of control. Maybe your supplier raised prices, or maybe your production process has become inefficient.
- Watch your "Freight-In": Shipping costs have skyrocketed lately. If you aren't including the cost of getting the goods to your door in your COGS, you are underestimating how much your product actually costs you.
Basically, COGS is the heartbeat of any business that sells physical things. It’s an expense, sure, but it’s the most important expense you’ll ever track. It tells you if your product is actually worth making. Everything else is just overhead.
To wrap this up, stop thinking of COGS as just another bill. It is the direct price of your revenue. If you can’t get that number right, the rest of your financial statements are essentially fiction. Start by separating your direct costs from your indirect ones this week. Look at your last three months of "purchases" and see how much of that stayed on the shelf versus how much actually went out the door. That clarity is where real profitability begins.