Definition (canonical)
COGS (Cost of Goods Sold) is the direct cost of producing what you sold in a period: materials, production labor, manufacturing overhead — the costs that scale WITH each unit sold. Revenue minus COGS = gross profit; everything below (sales, admin, R&D) is operating expense. The line between the two IS your gross margin — which makes the classification a strategic act, not bookkeeping trivia.
The test — does the cost ride along with a sale?
The sorting question: if you sold one more unit, would this cost grow? Factory materials and assembly wages — yes (COGS); the CEO's salary and the marketing budget — no (opex). Retail flavor: COGS = purchase cost of goods sold onward, computed as opening inventory + purchases − closing inventory (which is why inventory counts move profit — and why the balance sheet and the P&L must be read together). Grey zones that decide margins: shipping-in (COGS), shipping-out (usually selling expense), warehouse rent (allocations differ), payment processing (increasingly treated as cost of revenue in online models). The honest rule: pick a defensible convention, write it down, never bend it to flatter a quarter — margin TRENDS only mean something under a stable definition.
COGS in services and software — cost of revenue
Service firms rarely say "goods", but the concept holds as cost of revenue: delivery-team hours (the consultant's loaded cost on billable work), subcontractors, project travel — against which agency-style gross margins of 40–60% are read. SaaS canon: hosting and infrastructure, customer support, third-party licenses embedded in the product, DevOps share — healthy software gross margins run 70–85%, and investors read a lower number as "there's a human in the loop of every sale". The classification games are known: pushing support or infra into opex inflates gross margin optically — diligence teams reclassify in the first hour, so the vanity buys nothing and costs credibility. What COGS discipline actually buys you: true unit economics (contribution per sale), honest pricing floors, and early warning when scale erodes rather than improves the cost per unit.
FAQ
Is depreciation in COGS? Production machinery depreciation — yes; office equipment — opex; the asset's ROLE decides.
COGS vs variable costs — same thing? Overlapping, not identical: COGS can contain fixed factory overhead, and some variable costs (sales commissions) sit outside COGS — don't swap them in break-even math.
Why did my gross margin fall while sales grew? Usual suspects: input price inflation unpassed to customers, discount creep, product-mix shift toward low-margin lines, or scale-driven overtime — decompose per product before reacting.
Related: Margin · Income Statement · Pricing · Unit Economics Reviewed: 2026-07-20 · Sources: accounting canon