Calculating the Costs of Goods

By: Jennifer Brazer

Jennifer is the author of From Cubicle to Cloud and Founder/CEO of Complete Controller, a pioneering financial services firm that helps entrepreneurs break free of traditional constraints and scale their businesses to new heights.

Fact Checked By: Brittany McMillen

Calculating the Costs of Goods:
A Complete Guide to Pricing

Costs of goods directly impact your bottom line, representing all direct expenses associated with producing or purchasing the products your business sells. These costs include raw materials, direct labor, and manufacturing overhead—forming the foundation for pricing decisions and profit analysis.

In my 20+ years leading Complete Controller, I’ve seen how mastering costs of goods transforms struggling businesses into profitable powerhouses. The difference between success and failure often hinges on this critical metric—while the average U.S. business maintains a 52% gross margin, top performers can achieve 15-20% higher margins through strategic cost management. I’ve developed this comprehensive guide to help you implement proven strategies that have helped thousands of our clients optimize their product costs and pricing structures.

What are costs of goods and how do you calculate them?

• Costs of goods are the direct expenses involved in producing or purchasing products for sale, including materials, labor, and manufacturing overhead
• These costs form the basis of your COGS (Cost of Goods Sold) calculation, which measures what it costs to deliver your products
• COGS directly impacts your gross profit margin, revealing the efficiency of your core operations
• Understanding these costs enables strategic pricing decisions that balance competitiveness with profitability
• Proper cost tracking creates opportunities to identify inefficiencies and optimize your supply chain

What Are Costs of Goods? Breaking Down COGS

Costs of goods sold (COGS) represents the direct expenses associated with producing or purchasing the products your business sells during a specific period. These costs are directly tied to revenue generation and exclude indirect expenses like marketing, sales, and administrative overhead.

The oil and gas production sector operates with a staggering 58.78% average COGS ratio, while the information sector (including technology companies) maintains a much lower 32.4% ratio. This dramatic difference highlights how industry-specific cost structures fundamentally shape business models and pricing strategies.

Defining critical components

COGS typically includes these essential elements:

• Direct Materials: Raw materials that physically become part of the final product
• Direct Labor: Wages paid to workers directly involved in production
• Manufacturing Overhead: Factory utilities, equipment depreciation, and production supervision
• Freight-In Costs: Shipping charges for incoming materials
• Storage Costs: Expenses related to maintaining inventory before sale

Items generally excluded from COGS include:

• General administrative expenses
• Sales and marketing costs
• Research and development
• Distribution costs to customers

The distinction matters tremendously for accurate financial reporting and strategic decision-making. For example, a candle manufacturer includes wax, wicks, fragrance oils, and production worker wages in COGS, but excludes the marketing team’s salaries and office rent.

How to Calculate Costs of Goods Sold (COGS)

Calculating your COGS accurately provides the foundation for all pricing and profitability analysis. The core formula remains consistent across industries:

COGS = Beginning Inventory + Purchases – Ending Inventory

This straightforward equation captures the flow of inventory through your business during a specific accounting period.

Step-by-step implementation

1. Determine Beginning Inventory Value: Document the total value of inventory at the start of your accounting period, using consistent valuation methods
2. Track All Purchases: Record every purchase of inventory, raw materials, and direct production costs throughout the period
3. Calculate Ending Inventory Value: Conduct a physical count or perpetual inventory tracking to establish remaining inventory value
4. Apply the COGS Formula: Subtract ending inventory from the sum of beginning inventory plus purchases

For example, if a furniture manufacturer started January with $75,000 in inventory, purchased $125,000 in materials during the month, and ended with $50,000 in inventory, their COGS would be:

$75,000 + $125,000 – $50,000 = $150,000

This calculation reveals they converted $150,000 worth of inventory into sold products during January.

Case study: A textile manufacturer’s cost optimization

A mid-sized textile producer faced rising cotton prices that threatened their margins. By implementing precise inventory tracking and cost analysis, they identified opportunities to reduce waste and negotiate better terms with suppliers.

Their systematic approach included:

• Switching to just-in-time inventory management to reduce storage costs
• Renegotiating bulk purchase agreements with key suppliers
• Redesigning production processes to minimize material waste

The result? A 12% reduction in COGS while maintaining product quality, which translated directly to improved gross margins and competitive pricing advantages.

Advanced Cost Management Strategies

Strategic cost management goes beyond basic tracking to actively optimize each component of your COGS. Businesses that excel at cost management consistently outperform competitors in both profitability and market share.

Optimizing your supply chain

Your supply chain represents one of the richest opportunities for cost reduction without sacrificing quality. Consider these proven approaches:

• Strategic Sourcing: Evaluate suppliers based on total cost of ownership, not just unit price
• Vendor Consolidation: Concentrate purchases with fewer suppliers to gain volume discounts
• Long-Term Contracts: Negotiate price stability in exchange for committed purchase volumes
• Raw Material Hedging: Use futures contracts to lock in prices for volatile commodities
• Alternative Materials: Research substitutes that maintain quality while reducing costs

A European DIY retailer achieved an impressive 8-10% COGS reduction simply by renegotiating contracts with their top suppliers. Their approach focused on creating win-win partnerships rather than adversarial price squeezing, resulting in sustainable savings and improved supplier relationships.

Labor cost efficiency

Direct labor often represents a significant portion of COGS, offering substantial optimization potential:

1. Process Optimization: Map and streamline production workflows to eliminate redundancies
2. Skills Development: Cross-train employees to increase flexibility and reduce bottlenecks
3. Appropriate Automation: Identify repetitive tasks that technology can perform more efficiently
4. Quality Management: Reduce error rates and rework through standardized procedures
5. Production Scheduling: Minimize overtime through efficient capacity planning

Dalsin Industries, a metal fabrication company, demonstrated the power of process optimization when they reduced a 9-part assembly to a single piece through innovative redesign and automation. This transformation cut their COGS by 22% while improving product quality and consistency.

Pricing Strategies Beyond COGS

Understanding your costs provides the foundation for strategic pricing decisions, but effective pricing requires looking beyond COGS alone.

From break-even to profit mindset

The baseline approach to pricing starts with covering your costs but must expand to capture appropriate value:

• Cost-Plus Pricing: Adding a standard markup percentage to your COGS (e.g., COGS + 40%)
• Target Return Pricing: Setting prices to achieve specific ROI targets on invested capital
• Value-Based Pricing: Aligning prices with the perceived value to customers, independent of costs

The stark contrast between Microsoft’s 18.7% COGS ratio and Costco’s 86.1% illustrates how business models fundamentally shape pricing approaches. Microsoft’s software scales with minimal incremental costs, enabling high margins, while Costco deliberately operates on razor-thin margins to drive volume through competitive pricing.

Dynamic pricing tactics

Modern pricing strategies adapt to changing market conditions:

1. Segmented Pricing: Offering different prices to different customer segments based on their willingness to pay
2. Psychological Pricing: Using price points that trigger favorable psychological responses ($9.99 vs $10.00)
3. Promotional Pricing: Temporary discounts to drive volume or clear inventory
4. Premium/Economy Lines: Creating different product tiers to capture various price sensitivities
5. Bundle Pricing: Combining products at attractive total prices to increase average transaction value

The most successful pricing strategies align with your overall business positioning and customer expectations. A luxury brand using discount pricing tactics may damage their premium perception, while a value-oriented business charging premium prices will likely lose customers to competitors.

Impact of COGS on Profitability

COGS directly impacts your gross profit margin, which reveals the efficiency of your core production operations. This critical metric provides insights that financial statements alone might obscure.

Gross vs. Net profit margins

Understanding the relationship between different profit measures helps identify specific improvement opportunities:

Metric	Calculation	What It Reveals
Gross Profit	Revenue – COGS	Production efficiency
Operating Profit	Gross Profit – Operating Expenses	Operational effectiveness
Net Profit	Operating Profit – Taxes & Interest	Overall business profitability

 

Tracking these margins over time reveals trends that might otherwise remain hidden. For instance, a declining gross margin with stable operating expenses indicates increasing COGS—potentially from rising material costs, production inefficiencies, or unfavorable supplier terms.

Historical context matters tremendously when analyzing these trends. Consider how U.S. inflation peaked at 17.8% in 1917, driving massive raw material cost increases, compared to 4.1% in 2023. These macroeconomic shifts dramatically impact COGS across industries, requiring adaptive strategies to maintain margins.

When COGS spikes: Identifying root causes

When your COGS suddenly increases, systematically investigate these common culprits:

1. Supply Chain Disruptions: Transportation delays, material shortages, or supplier problems
2. Commodity Price Volatility: Sudden increases in raw material market prices
3. Production Inefficiencies: Higher scrap rates, longer production times, or quality issues
4. Volume Changes: Lower production volumes spreading fixed costs across fewer units
5. Hidden Costs: Previously overlooked expenses now properly categorized as COGS

Diagnosing the specific cause enables targeted interventions rather than across-the-board price increases that might damage customer relationships.

Common Mistakes & Best Practices

After working with thousands of businesses across industries, I’ve observed patterns that separate cost management leaders from laggards.

Pitfalls to avoid

Watch for these common mistakes that undermine accurate COGS tracking and management:

• Inconsistent Inventory Valuation: Switching between methods (FIFO/LIFO) without proper accounting adjustments
• Misclassified Expenses: Incorrectly including non-direct costs in COGS calculations
• Overlooking Hidden Costs: Failing to capture all direct production expenses
• Manual Tracking Systems: Relying on spreadsheets instead of integrated inventory management
• Delayed Analysis: Reviewing COGS quarterly instead of implementing real-time monitoring

Pro tips from Complete Controller

From my experience guiding businesses through financial transformations, these practices consistently deliver results:

• Implement Three-Way Matching: Verify purchase orders against receiving documents and supplier invoices before recording inventory costs
• Regular Inventory Audits: Conduct cycle counts to identify discrepancies before they compound
• Cost Driver Analysis: Identify which specific inputs most significantly impact your total COGS
• Supplier Scorecards: Evaluate vendors on quality, reliability, and total cost—not just price
• Scenario Planning: Model how potential cost changes would impact margins and pricing requirements

One manufacturing client discovered that 15% of what they classified as direct production costs actually represented indirect expenses misallocated to COGS. Reclassifying these costs immediately improved their gross margin visibility and highlighted opportunities for targeted process improvements.

Final Thoughts: Transforming Cost Management into Competitive Advantage

Mastering your costs of goods creates a foundation for strategic pricing and sustainable profitability. The businesses that thrive don’t just track costs—they actively manage them as a core competitive differentiator.

I’ve seen companies transform their financial trajectory by applying the principles outlined in this guide. The key lies in systematic implementation: establish accurate baseline measurements, identify specific improvement opportunities, implement targeted changes, and continuously monitor results.

Ready to optimize your costs of goods and develop more strategic pricing? The expert team at Complete Controller can help you implement these practices with systems tailored to your specific business needs. Contact us today to start your journey toward improved margins and more competitive pricing.

FAQ

How do costs of goods differ from operating expenses?

Costs of goods include direct expenses related to producing or purchasing products for sale (materials, labor, manufacturing overhead), while operating expenses cover running the business (rent, utilities, marketing, administrative salaries). The key distinction: COGS is directly tied to creating your product, while operating expenses would continue even if production temporarily stopped.

Which inventory valuation method is best for calculating COGS?

The best method depends on your business context. FIFO (First-In, First-Out) typically provides the most accurate inventory valuation during inflation and aligns with physical inventory flow. LIFO (Last-In, First-Out) can provide tax advantages during inflation but may understate inventory value. Weighted average works well for commodities or identical items where individual tracking isn’t practical.

Can service-based businesses have costs of goods?

Yes, service businesses can have COGS, though they’re sometimes called “cost of services.” These include direct labor performing the service, materials used in service delivery, and contractor payments. For example, a consulting firm would include consultant salaries and project-specific expenses in their cost of services, but exclude office rent and administrative staff.

How can I reduce my COGS without sacrificing quality?

Focus on efficiency rather than cutting corners. Negotiate volume discounts with suppliers, optimize production processes to reduce waste, implement just-in-time inventory to lower carrying costs, invest in automation for repetitive tasks, and regularly review make-vs-buy decisions. The goal is eliminating inefficiency and waste while maintaining or improving your product quality.

How often should I analyze my COGS?

At minimum, review COGS monthly to identify trends before they significantly impact profitability. Businesses with volatile input costs or tight margins should implement weekly monitoring of key cost drivers. Additionally, conduct comprehensive quarterly analyses to identify seasonal patterns and opportunities for strategic improvements. Real-time visibility into cost changes enables proactive pricing adjustments and procurement decisions.

Sources

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  • https://www.netsuite.com/portal/resource/articles/financial-management/cost-of-goods-sold-cogs.shtml
• Board of Directors of Canada. “What is the Cost of Goods Sold (COGS).” BDC.ca.
• US Chamber of Commerce. (2025). “What Is Cost of Goods Sold.”
• Sage. (2024). “Cost of Goods Sold: What is it and how to calculate it.”
• Launchnotes. (2024). “How to Calculate Pricing for a Product.”
• NYU Stern. (2025). “Operating and Net Margins by Sector.”
  • https://pages.stern.nyu.edu/~adamodar/NewHomePage/datafile/margin.html
• FasterCapital. (2023). “Average COGS Ratios Across Sectors.”
  • https://fastercapital.com/topics/a-comparison-of-the-average-cogs-ratios-across-different-sectors.html
• Federal Reserve Bank of Minneapolis. (2025). “Consumer Price Index, 1913-2025.”
  • https://www.minneapolisfed.org/about-us/monetary-policy/inflation-calculator/consumer-price-index-1913-
• Dalsin Industries. (2025). “Case Studies.”
  • https://www.dalsinind.com/case-studies.html
• Oliver Wyman. (2014). “Cutting COGS: Going Beyond Supplier Negotiations.”
  • https://www.oliverwyman.com/content/dam/oliver-wyman/global/en/2014/jul/201408OWCutting%20COGS_ENG.PDF
• Wikipedia. “Cost of Goods Sold.”
  • https://en.wikipedia.org/wiki/Costofgoods_sold
• Investopedia. “Supply Chain Management.”
  • https://www.investopedia.com/terms/s/supply-chain-management.asp
• Investopedia. “Value-Based Pricing.”
  • https://www.investopedia.com/terms/v/value-based-pricing.asp
• Complete Controller. “Managing Business Accounting.”
• Complete Controller. “Cut Custom Assembly Costs: 5 Ways.”
• Complete Controller. “Net Profit Margin: Business Essential.”

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