When it comes to managing your business finances, understanding what is included in Cost of Goods Sold (COGS) is crucial. For small business owners and self-employed entrepreneurs, getting this part right can make all the difference in accurate bookkeeping, smart pricing, and maximizing profits. In this blog, we’ll break down what is included in Cost of Goods Sold, how to calculate it, and why it matters—especially when using a smart tool like Otto AI to help manage your financial workflows more efficiently.
What Is Cost of Goods Sold (COGS)?
The Cost of Goods Sold (COGS) refers to the direct costs associated with the production of goods or services that a business sells. It includes expenses directly tied to the creation or acquisition of the product, but excludes indirect costs like marketing, rent, or utilities.
COGS is subtracted from revenue to determine gross profit, a critical metric that reflects how efficiently your business produces goods or services.
Why Is Understanding COGS Important?
For self-employed professionals and small businesses, tracking COGS accurately helps in:
- Setting profitable pricing strategies
- Understanding profit margins
- Managing inventory efficiently
- Filing accurate tax returns
- Getting real-time insights with tools like Otto AI
Otto AI simplifies this process by automating the tracking and calculation of COGS-related entries, making it easy for entrepreneurs to focus more on growth and less on accounting.
What Is Included in Cost of Goods Sold?
Let’s explore the main components typically included in COGS for small businesses:
1. Raw Materials and Supplies
Any material directly used in creating a product is part of COGS. For instance, if you sell handmade soaps, items like essential oils, fragrances, and packaging are included.
2. Direct Labor Costs
This includes wages paid to employees or contractors who are directly involved in the production of goods. For a clothing business, this could mean the hourly pay of tailors or seamstresses.
3. Factory Overheads (Directly Related to Production)
Expenses like equipment maintenance, utility costs for production areas, and depreciation of manufacturing equipment fall under this category.
4. Inventory Costs
Any inventory bought for resale is part of COGS. For example, a retailer who purchases electronics for resale would include the purchase cost in COGS.
5. Shipping and Freight (Inbound)
Costs for shipping raw materials to your location are included, but outbound shipping to customers is not. This often causes confusion but is essential in accurate reporting.
6. Packaging Costs (If Required for Sale)
If the packaging is an essential component of selling the product—like a bottle for a beverage or a box for a tech gadget—it is included in COGS.
What Is NOT Included in COGS?
To avoid mistakes, be clear about what is excluded from COGS:
- Sales and marketing expenses
- Office rent and utilities
- Administrative salaries
- Outbound shipping to customers
- Research and development costs
These are operating expenses and should be categorized separately. Tools like Otto AI help you distinguish between direct and indirect costs so your COGS remains accurate and audit-ready.
How to Calculate Cost of Goods Sold
The basic COGS formula is:
COGS = Beginning Inventory + Purchases During the Period – Ending Inventory
Example:
Let’s say you run a small handcrafted jewelry business.
- Beginning Inventory (Jan 1): $5,000
- Purchases (materials, supplies, labor): $10,000
- Ending Inventory (Dec 31): $4,000
Then,
COGS = $5,000 + $10,000 – $4,000 = $11,000
This means you spent $11,000 to produce the goods you sold throughout the year.
With Otto AI, this calculation can be automated by integrating with your inventory system, saving time and reducing human error.
How Otto AI Helps Manage and Analyze COGS
Otto AI is designed with small businesses in mind. Here’s how it supports entrepreneurs in managing COGS efficiently:
1. Automated Expense Categorization
Otto AI automatically classifies expenses into appropriate categories—ensuring that direct costs are tracked under COGS while others are filed as operating costs.
2. Inventory Integration
Sync your inventory management system with Otto AI to track stock levels and values in real time. This helps keep COGS updated with current data.
3. Smart Reporting Dashboards
Otto AI generates clear, actionable financial reports including gross profit margins and expense breakdowns, helping you make strategic decisions fast.
4. Tax-Ready Records
Otto AI ensures all COGS-related entries are audit-friendly and aligned with tax regulations, which is a huge help during tax season.
COGS Best Practices for Small Businesses
Here are a few tips to maintain accuracy and improve your bottom line:
- Update Inventory Regularly: Don’t wait until year-end. Use Otto AI to maintain real-time inventory valuations.
- Separate Costs Clearly: Use dedicated accounts for direct and indirect costs to avoid mixing expenses.
- Track Labor Efficiently: Record labor hours specifically used in production instead of lumping all wages together.
- Review COGS Monthly: Regular reviews help you identify cost inefficiencies and price your products accordingly.
Final Thoughts
Understanding what is included in Cost of Goods Sold is a fundamental part of running a profitable business. It gives you deeper insight into how much you’re really spending to deliver your products or services. For small business owners and self-employed entrepreneurs, getting this calculation right can impact everything from pricing strategy to tax liability.
With Otto AI, managing and optimizing your COGS becomes seamless. From automated calculations to smart reporting, Otto AI is the perfect financial companion to help your business grow smarter.