Qualifying
What is cost of goods sold (COGS)?
Cost of goods sold (COGS) is the direct cost of producing the goods or services your business sold during a period — raw materials, direct labor, manufacturing overhead. It's subtracted from revenue to calculate gross profit.
The full picture
Cost of goods sold (COGS) is the total of all direct costs attributable to the goods or services your business sold in a given period. The IRS defines it and its deductibility in Publication 334 (Tax Guide for Small Business). On your income statement: Revenue − COGS = Gross Profit. Gross profit is the starting line from which all other operating expenses are subtracted to arrive at net income.
What's included in COGS?
COGS includes only costs directly tied to production or acquisition of the goods sold — not overhead or selling costs:
- Raw materials and components purchased for production.
- Direct labor costs (wages for workers directly producing goods).
- Manufacturing overhead directly associated with production (factory rent, production equipment depreciation).
- The purchase cost of finished goods you resell (wholesale/retail inventory).
- Freight-in costs for bringing inventory to your location.
What is NOT included in COGS
Selling expenses (sales commissions, advertising), general and administrative costs (executive salaries, office rent), and interest on loans are not part of COGS — they appear lower on the income statement as operating expenses or below-the-line items. Mixing them into COGS overstates product costs and distorts your gross margin.
How COGS is calculated
The standard formula: Beginning Inventory + Purchases During the Period − Ending Inventory = COGS. Businesses track this using inventory costing methods — FIFO (first in, first out), LIFO (last in, first out), or weighted average — and the IRS requires consistent application of whichever method you choose. Service businesses with no physical inventory often have minimal or no COGS, reporting costs as operating expenses instead.
COGS discipline connects to broader pricing and cost-accounting strategy — ClearValue Books' COGS glossary entry pairs the definition with book-length reading on cost accounting for owners who want to go deeper than a single line item.
Why COGS matters for lenders and underwriting
When a lender reviews your business financials, COGS is one of the first signals they examine. A stable or improving gross margin (revenue minus COGS as a percentage) indicates pricing power and cost discipline. Erratic or rapidly rising COGS without revenue growth is a red flag. If you're applying for business financing and want to put your best foot forward, make sure your profit and loss statement clearly separates COGS from operating expenses. ClearValue Lending routes your application to the funding partners best matched to it — your financials go to the partners reviewing your file. Start an application when you're ready. Consult a CPA or bookkeeper on proper COGS classification for your industry.
IRS on COGS
- The IRS treats the cost of goods sold as a deduction from gross receipts when computing taxable income for businesses that sell or produce merchandise. — IRS Publication 334
- Businesses must use a consistent inventory valuation method (FIFO, LIFO, or weighted average) and generally cannot change methods without IRS approval. — IRS Publication 334
- COGS is calculated as: beginning inventory + purchases − ending inventory. — IRS Publication 334
Key takeaways
- COGS = Beginning Inventory + Purchases − Ending Inventory; it covers only direct production costs.
- Subtract COGS from revenue to get gross profit — the first profitability metric on your income statement.
- Selling, G&A, and interest expenses are not COGS — they go lower on the income statement.
- Lenders scrutinize gross margin trends when underwriting; clean COGS reporting helps your application.
- The IRS requires consistent inventory costing — consult a CPA if you're unsure which method applies.
Frequently asked questions
What is the formula for cost of goods sold?
COGS = Beginning Inventory + Purchases During the Period − Ending Inventory. This covers only costs directly tied to producing or acquiring the goods you sold — materials, direct labor, and directly associated manufacturing overhead. Source: IRS Publication 334.
Is cost of goods sold the same as operating expenses?
No. COGS covers only direct production or acquisition costs. Selling expenses (commissions, advertising), general and administrative costs (executive salaries, office rent), and interest on loans are operating expenses, not COGS — they're subtracted separately, lower on the income statement. Mixing the two overstates product cost and distorts gross margin.
Does a service business have cost of goods sold?
Usually minimal or none. Businesses with no physical inventory — most service businesses — typically report their direct costs as operating expenses instead of COGS, since COGS is built around inventory and production costs.
Why do lenders care about cost of goods sold when underwriting a business loan?
Gross margin (revenue minus COGS, as a percentage) is one of the first signals a lender reviews. A stable or improving gross margin indicates pricing power and cost discipline; erratic or rising COGS without matching revenue growth is a red flag. Keeping COGS clearly separated from operating expenses on your profit-and-loss statement helps present an accurate underwriting picture.
Which inventory costing method should I use to calculate COGS?
FIFO (first in, first out), LIFO (last in, first out), and weighted average are the standard methods. The IRS requires businesses to apply their chosen method consistently and generally does not allow switching methods without approval. A CPA or bookkeeper can advise which method fits your industry and inventory type. Source: IRS Publication 334.
Published 2026-05-22 · Updated 2026-08-16 · https://clearvaluelending.com/answers/what-is-cost-of-goods-sold