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.

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.

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 one matched lender partner — your financials go to one place. 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.