What is the Cost of Goods Sold (COGS)?

How Cost of Goods Sold Works

COGS calculation follows a straightforward formula across all business types. Beginning Inventory represents the value of goods or materials at the start of the accounting period. Purchases during the period add to this amount. Ending Inventory (the value remaining at period close) is subtracted from the sum, yielding COGS. For manufacturing and retail businesses, inventory valuation directly determines the COGS figure.

The complexity lies in inventory valuation method selection. FIFO (First In, First Out) assumes the oldest inventory sells first. During rising prices, FIFO produces lower COGS and higher reported profits. LIFO (Last In, First Out) assumes the newest inventory sells first. During rising prices, LIFO yields higher COGS and lower reported profits, which reduces tax liability. The Average Cost Method divides total costs by total units to produce a blended per-unit cost, smoothing out price fluctuations. Specific identification tracks costs to individual units for unique high-value items.

For service businesses like MSPs, COGS consists primarily of direct labor costs (technician salaries and benefits) and software licenses tied to service delivery. Labor typically represents 90% or more of service COGS. Unlike product businesses, service providers do not carry physical inventory. Their COGS reflects the direct costs incurred to deliver each billable hour or managed service engagement.

Why Cost of Goods Sold Matters

COGS determines gross profit and gross profit margin, the primary indicators of operational efficiency and pricing effectiveness. For MSPs and IT service providers, maintaining COGS between 50% and 65% of revenue signals healthy financial performance (Thread, 2024). Service businesses with gross margins below 50% face operational inefficiencies that compress profitability and limit growth capacity.

Understanding COGS composition allows IT service businesses to identify cost control opportunities. Since labor constitutes 90% or more of service COGS (Hannemann, 2024), technician utilization becomes the primary lever for controlling direct costs in managed IT service delivery. Businesses that track COGS accurately can evaluate pricing strategy, make informed staffing decisions, and allocate costs correctly between direct delivery expenses and overhead.

Misallocating COGS distorts financial reporting and masks true production costs. A common mistake involves placing all labor costs in operating expenses rather than splitting direct production labor into COGS. This error understates cost of service delivery, inflates gross margin artificially, and prevents leadership from understanding the actual cost to fulfill each client engagement. Accurate COGS tracking provides the foundation for sustainable pricing and profitability management.

Cost of Goods Sold vs. Operating Expenses

The key difference is that COGS includes only costs directly attributable to producing what you sell, while operating expenses cover the indirect costs required to keep the business running.

Common Misconceptions

COGS is not the same as total expenses. COGS captures only the direct costs of production or service delivery, while total expenses include operating overhead like rent, marketing, and administrative salaries that exist whether you sell one unit or a thousand.

COGS does not include all labor costs. Only technician salaries and benefits directly tied to service delivery belong in COGS. Administrative staff, sales personnel, and management salaries are operating expenses, even though separating direct labor from overhead labor requires deliberate cost allocation.