Cost of Goods Sold (COGS) and Cost of Sales Guide

Cost of goods sold, or COGS, is the cost assigned to products a business sold during a period. For an inventory business, it generally begins with inventory available for sale and subtracts ending inventory. Cost of sales is often used as a synonym, although some businesses use that phrase more broadly for direct product or service-delivery costs.

Common inventory formula: Beginning inventory + purchases and applicable production costs − ending inventory = cost of goods sold

COGS is subtracted from net sales to calculate gross profit. It is normally presented above operating expenses on a profit and loss statement.

Key rule COGS should not be deducted twice. The same cost must not appear in both cost of goods sold and operating expenses. The label "direct" is not enough — the business needs a consistent method tied to how goods are acquired or produced.

How cost of goods sold is calculated

For a merchandising business, the basic calculation is:

Beginning inventory
+ Purchases
+ Freight-in and other applicable acquisition costs
− Items withdrawn for personal use or other required reductions
= Goods available for sale
− Ending inventory
= Cost of goods sold

A manufacturer may also include direct labor, materials and supplies, and allocable factory or production overhead under the applicable accounting and tax rules.

The formula matches cost with the goods sold. Purchases that remain in ending inventory generally are not all treated as current-period COGS.

COGS example

Assume a California product business has:

COGS component	Amount
Beginning inventory	$20,000
Net purchases	$90,000
Direct production labor	$15,000
Freight-in and production supplies	$5,000
Goods available for sale	$130,000
Less ending inventory	($25,000)
Cost of goods sold	$105,000

If net sales are $150,000:

$150,000 net sales − $105,000 COGS = $45,000 gross profit

The gross profit margin is 30%: $45,000 ÷ $150,000 = 30%

This is not net profit. The business still subtracts operating expenses, interest, taxes, and other applicable items.

What can be included in COGS?

Depending on the business and applicable rules, COGS may include:

Merchandise purchased for resale
Raw materials and components
Freight-in and certain acquisition costs
Direct labor that produces goods
Manufacturing supplies
Allocable production overhead
Other costs required to be capitalized into inventory

What usually is not COGS?

Common operating costs often reported below gross profit include:

General advertising and selling costs
Office administration
Bookkeeping, legal, and general professional fees
General business insurance
Owner draws or distributions
Loan principal
Income tax payments
Costs unrelated to producing or acquiring the goods sold

Some costs require allocation. Rent and utilities for a factory may be treated differently from rent and utilities for an administrative office.

COGS vs. cost of sales

Businesses and software frequently use COGS and cost of sales interchangeably, which is why one canonical page covers both terms.

However, "cost of sales" can be used more broadly. A service company may track direct delivery labor, subcontractors, hosting, or other costs in a cost-of-services or cost-of-revenue section to analyze gross margin. That management presentation does not automatically mean those costs are inventory-based tax COGS.

The financial-statement label should be understood in context. Tax reporting follows the applicable tax rules, entity return, accounting method, and facts.

COGS vs. operating expenses

COGS relates to acquiring or producing what was sold. Operating expenses support the business more generally. The distinction matters because:

COGS determines gross profit and gross margin.
Classification affects period comparisons and pricing analysis.
Inventory can defer recognition of some costs until goods are sold.
Tax forms often report COGS separately from business expenses.
Inconsistent classification can create misleading trends.

Where COGS appears on tax returns

For a sole proprietor using Schedule C, Part III calculates cost of goods sold. In the 2025 Schedule C structure discussed in IRS Publication 334, lines 35 through 42 cover beginning inventory, purchases, cost of labor, materials and supplies, other costs, ending inventory, and COGS. COGS then reduces gross receipts in calculating gross profit.

Partnership and corporation returns also contain COGS sections or supporting schedules. The exact form, lines, and disclosures depend on entity type, tax year, activity, accounting method, and reporting requirements. Review the current form each year rather than relying on a prior-year line number.

Records supporting COGS

Useful support includes:

Beginning and ending physical inventory counts
Purchase invoices and receiving documents
Freight and import records
Production payroll and time records
Bills of materials and job-cost records
Manufacturing-overhead allocations
Records of damaged, obsolete, donated, or personally withdrawn inventory
Inventory-valuation policies and method-change filings
General-ledger and tax-return reconciliations

Common mistakes

Deducting all purchases even when goods remain in ending inventory
Counting the same cost in COGS and operating expenses
Including sales, administrative, or owner costs without support
Omitting freight-in or production costs that should be inventoried
Failing to count inventory consistently at year end
Treating cost of services as tax COGS without reviewing the facts
Changing inventory methods informally
Comparing gross margins when classifications changed
Assuming a bookkeeping label proves tax deductibility

Heath Income Tax

Heath Income Tax can help product businesses reconcile inventory and COGS records, produce useful gross-margin reports, and coordinate bookkeeping classifications with federal and California tax preparation.

Bookkeeping Services Business Tax Prep

Frequently asked questions

Is cost of sales the same as cost of goods sold?

Often, yes. Some businesses use cost of sales more broadly, especially for services. The page and records should explain what the line includes.

Do service businesses have COGS?

A pure service business may not have inventory-based COGS. It may track direct service-delivery costs for management reporting, but tax classification depends on the facts and rules.

Does inventory purchased reduce profit immediately?

Not always. Costs assigned to ending inventory generally remain an asset until the related goods are sold or otherwise properly recognized.

Is COGS a business expense?

It reduces gross receipts in determining gross profit, but tax forms often report it separately from operating deductions. It should not be deducted twice.

Can labor be included in COGS?

Direct production labor may be included. Administrative, selling, and owner labor require separate analysis, and sole proprietors do not deduct their own draws as wages.

Related terms

Official sources

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The definitions and examples on this page are for informational purposes only and do not constitute tax advice. Tax laws change frequently and individual circumstances vary. Consult a qualified tax professional before making decisions based on this content.