COGS is an important financial metric that measures operating efficiency and performance. COGS categorization is subject to the nature of the business. Even in the same industry, some expenses will be categorized as a COG but in other companies, they will be treated as operating expenses.
For software companies, Cost Of Goods Sold (COGS) can include, for example, hosting fees, third party licensing fees, credit card processing fees, customer onboarding fees, and support costs. For a company with a physical product, COGS for a given time period is calculated by adding the inventory left over from the last period and any new purchases, then subtracting the inventory left over at the end of the period.
COGS helps the business and its investors and analysts track performance and understand the bottom line. It is tracked as a business expense and is subtracted from a company’s revenue to get Gross Margin. A favourable trend for COGS depends on the stage the product and organization is at. In general, COGS should become more efficient over time resulting in increased gross margins.
Components of COGS (Cost of Goods Sold)
COGS typically includes all direct costs associated with producing goods or delivering services:
For product-based companies:
- Raw materials and inventory
- Direct labor costs involved in production
- Manufacturing overhead directly tied to production
- Factory utilities and equipment maintenance
- Shipping and freight-in costs
- Quality control costs
- Product packaging
For service-based companies:
- Direct labor delivering the service
- Subcontractor costs for service delivery
- Materials used in service delivery
- Equipment costs directly related to service provision
For technology/digital companies:
- Cloud hosting and infrastructure costs
- Third-party software licenses that directly enable the service
- Customer support personnel directly servicing customer
- Implementation teams and professional services delivery staff
- Data center operations
- Payment processing fees related to revenue
COGS explicitly excludes operating expenses such as R&D/engineering (outside of direct service delivery), sales, marketing, and general administrative costs.