How cogs works
COGS includes only costs directly tied to the product sold, such as raw materials, manufacturing labor, freight to bring goods in and landed cost adjustments. It excludes indirect costs like rent, marketing and administrative salaries, which are classified as operating expenses further down the income statement.
For a retailer or manufacturer, COGS is usually calculated as beginning inventory plus purchases minus ending inventory, so accurate inventory counts directly affect the reported figure. Getting COGS right matters because it drives gross margin, one of the first numbers a lender or buyer checks when reviewing a company's financials. Businesses that sell services rather than physical products calculate a similar figure, often called cost of services, covering the direct labor and materials tied to delivering the service rather than a physical unit sold. Either way, the goal is separating direct, variable costs from the fixed overhead that keeps the business running regardless of sales volume.
Example
A company starts the month with $20,000 of inventory, purchases $15,000 more, and ends the month with $12,000 on hand. COGS for the month is $20,000 plus $15,000 minus $12,000, which equals $23,000. On $40,000 of revenue, that gives a gross profit of $17,000 and a gross margin of 42.5%. If the same company's ending inventory count is later found to be overstated by $2,000 due to a counting error, COGS would actually be $2,000 higher and gross profit $2,000 lower once the correction is made.
COGS in QuickBooks Online vs Xero
QuickBooks Online calculates COGS automatically for inventory items tracked using its built-in Inventory feature, posting to a COGS account each time a sale is recorded. Xero tracks COGS the same way through its inventory items, though both platforms use average cost, not FIFO, so landed cost and shrinkage adjustments often need a manual journal entry.
Related terms
How LedgerBPO handles cogs
We reconcile inventory counts, purchases and landed costs each month so your COGS and gross margin numbers reflect what actually happened, not just what your software's default costing method assumes. This gives you a reliable gross margin figure to price products and spot cost creep early.