Key Takeaways:
- COGS shows the true cost of your products, including all direct costs to make or buy your goods, like materials, labour, packaging, and shipping, but excluding general business expenses.
- Calculating COGS (using methods like FIFO, WAC, or special consideration) helps you monitor margins, spot slow-moving stock, adjust pricing, and make smarter purchasing decisions.
- Tactics like negotiating with suppliers, sourcing cheaper materials without sacrificing quality, and considering offshore production can help reduce COGS.
If you run an SME, understanding your cost of goods sold (COGS) is non-negotiable.
Simply put, COGS is how much it costs your business to produce or buy the products you sell. It covers everything that goes directly into getting a product ready for sale, but not your everyday running costs.
Keeping track of COGS isn’t just an accounting exercise—it’s a powerful tool for managing profitability, pricing, and inventory, helping you make smarter decisions, stop money from leaking out, and stay on top of your tax obligations.
What is cost of goods sold (COGS)?
Cost of goods sold, or COGS, is how much it costs your business to produce or buy the products you sell. Generally, this includes:
- Direct materials: The raw materials that go into your products
- Direct labour: The wages paid to workers directly involved in production
- Manufacturing overheads: Things like factory rent and utilities, depreciation of equipment, and factory supplies
- Packaging: Self-explanatory—the packaging required to sell the product, if any
- Shipping and handling: Costs of transporting materials to your factory and your products to the point of sale
In a nutshell, COGS = everything you spend to get your product ready to sell, excluding general business operations.
What doesn't qualify as COGS?
Costs not directly tied to producing or acquiring goods are not considered COGS. Think salaries for non-production staff, marketing and advertising, shipping to customers, and R&D.
What's the difference between COGS and cost of sales (COS)?
Although often used interchangeably, COGS and COS aren't exactly the same.
We know by now that COGS covers the direct costs of creating products, and it's commonly used in product-based businesses.
COS, on the other hand, includes those same direct costs, plus additional expenses tied to making a sale, like sales commissions or transaction fees. You’ll see COS more often in service businesses or businesses that combine products and services.
Why is COGS important for SMEs?
Keeping tabs on your COGS gives you clear insights into your profitability, supports strategic pricing, helps you maintain optimal inventory, and ensures your paperwork stacks up at tax time.
Work out how profitable you are
COGS is the foundation for understanding profitability. Subtract it from revenue and you get your gross profit—whatever's left over before operating expenses, tax, or loan repayments.
If your COGS is too high, even strong sales won’t translate into healthy profits. You need to keep an eye on it to gauge whether your business model is actually sustainable.
Set prices with confidence
Knowing your COGS helps you set prices that make sense. It tells you the true cost per unit and the baseline costs you need to go over in order to cover overheads, stay competitive, and make a profit.
Plus, you can more easily keep track of cost fluctuations and adjust prices without second-guessing.
Keep your stock in check
When you look at your COGS and sales side by side, you get a clear view of which products are flying off the shelves and which are just sitting there. From there, you can make smarter purchasing decisions, avoid overstocking, and free up cash for other priorities.
You can also spot slow-moving items early and run promos, bundles, or discounts before they become dead stock.
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Stay on top of your tax obligations
COGS is tax-deductible. Staying on top of it—and keeping all purchase records, invoices, freight, and production costs—helps you maximise deductions come tax time.
If you're registered for GST, tracking COGS also means you’re capturing GST credits on stock purchases, keeping your BAS accurate.
And, it may help you avoid red flags with the ATO by showing a clear link between your costs and your sales, making your tax reporting consistent and reliable.
How to calculate COGS
Calculating your COGS doesn’t have to feel like rocket science. Here’s the simple formula every SME should know:
Beginning inventory + Purchases - Ending inventory
Let's break it down:
- Beginning inventory is the value of the stock you had at the start of the period
- Purchases are the cost of buying or producing additional stock during the period
- Ending inventory is the value of the stock you still have left at the end of the period
Now, let's put it into practice:
Say you start the month with $9,000 worth of stock, buy another $4,000 in supplies, and finish the month with $6,000 still on the shelves.
($9,000 + $4,000) - $6,000 = $7,000 COGS
This means $7,000 worth of stock was sold during that period.
How often should you calculate COGS?
At minimum, calculate COGS once per financial year when lodging your tax return. However, adopting a more regular cadence—like quarterly or even monthly—may be a smarter move, especially if you have a high inventory turnover.
That way, you can keep a closer eye on margins and stock levels, rather than being caught off guard by unexpected costs or shrinking profits at year-end.
Can I estimate my COGS?
You can estimate your COGS, and it's actually a common practice for small businesses without exact inventory records.
Look at past sales, track your production or purchase costs, or calculate based on average costs per unit sold.
Just remember, estimates are a guide. Although they can help with budgeting, pricing, and forecasting, you should still reconcile with actual numbers at tax time to stay accurate and compliant.
COGS accounting methods
Not all inventory and businesses are the same, so using different accounting methods for COGS helps reflect the reality of your stock, costs, and profits.
First in, first out (FIFO)
The FIFO method assumes your oldest stock goes out the door first. When prices go up, FIFO usually reports lower COGS and higher profit because you’re selling your older, cheaper stock first.
This can work well if you sell perishables or time-sensitive products that can become obsolete, like food, fashion, or tech, reflecting the natural flow of inventory.
Weighted average cost (WAC)
WAC calculates an average cost for all inventory, so each item sold is assigned the same cost. This is a suitable solution if you're selling large volumes of identical items, like hardware or bulk goods.
This simplifies record-keeping and gives consistent COGS value over time, which is especially useful when purchase prices fluctuate frequently.
Special consideration
The special consideration method tracks the exact cost of each individual item sold. This is more accurate but also more time-consuming, so it's less common than FIFO or WAC.
It can be very useful if you sell high-value or unique products, like cars or artwork—matching each item’s cost to its sale and supporting profitability and tax reporting.
How to manage and reduce COGS
Reducing your COGS isn’t just about slashing costs—it’s about being strategic and finding smarter ways to run your business:
Talk through pricing with your suppliers
Suppliers often have some flexibility on price, especially if you buy often or in larger quantities, so why not try negotiating? Even small discounts on materials or shipping can add up and reduce your overall COGS.
Buy in bulk to bring prices down
Purchasing larger quantities often unlocks wholesale pricing or volume discounts, and it can be a smart move for non-perishable items or products with steady demand.
Just make sure that you have enough storage space and that your stock (and money) won’t go to waste.
Find cheaper materials (without compromising quality)
Every once in a while, it's worth doing some research and looking for alternative suppliers, materials, or components that cost less than your current ones.
Once again, even small savings per unit can add up. Multiply them across all units sold, and you might be surprised.
Just remember that cutting costs shouldn’t mean cutting your reputation. Take your time testing out new materials, only make the switch if you find an option that doesn't lower the quality of your products.
Look into offshore production
Manufacturing overseas can sometimes significantly reduce production costs, especially for labour-intensive items. This works best for businesses that produce in large volumes and can manage longer supply chains.
Don't forget to factor in shipping, customs, and lead times, though. Sometimes “cheap” production abroad isn’t actually cheaper once all costs are included.
Need a cash boost to stock up or ship overseas? Trade finance can help you keep your business moving—Valiant makes it easy.
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