finance
COGS (Cost of Goods Sold)
Direct costs of delivering the product or service - materials, direct labor, delivery costs.
Definition
COGS (Cost of Goods Sold) includes only the direct costs of producing or delivering what you sell: materials, direct labor (people whose time goes into the product/service), packaging, delivery, payment processing. It excludes overhead (rent, admin, marketing). For service businesses, COGS is mostly the loaded labor cost of the people delivering the service. The discipline of clean COGS accounting is what makes gross margin actually meaningful - mix overhead into COGS and you lose the signal.
COGS for product versus service businesses
For US product businesses: COGS includes raw materials, manufacturing labor, freight in, warehousing for inventory, packaging, and direct manufacturing overhead (factory rent, utilities allocated to production). For US service businesses: COGS includes loaded labor cost of billable team (salary plus payroll tax plus benefits times percentage billable), subcontractor fees, software directly tied to delivery (e.g., a per-client SaaS license), and payment processing fees. The cleanest test: would this cost disappear if you sold zero units this month? If yes, it is COGS. If no, it is OpEx. The IRS does not enforce a strict definition for service businesses, but consistency matters for management reporting and audit.
Loaded labor cost calculation
For service businesses, COGS is dominated by loaded labor cost. Base salary is not enough; load it with employer-paid payroll tax (about 7.65 percent FICA in the US), employer benefits (health insurance 6 to 12 percent of salary, 401k match 3 to 6 percent), paid time off (about 8 percent of compensation), and an overhead allocation if you want full absorption. A 100K base salary lands at roughly 130 to 145K loaded cost in the US. Divide loaded cost by billable hours (typically 1500 to 1700 per year for senior consultants, 1800+ for junior) to get hourly loaded cost. This is the true cost per billable hour, which sets pricing floors.
Tracking COGS per project or per customer
Aggregate COGS tells you whether the business model works. Per-project COGS tells you which projects are profitable. The best US service businesses tag every dollar of COGS to a project ID in QuickBooks, Xero, or a PSA tool (Mavenlink, Kantata, Harvest). At month-end, gross margin per project surfaces silent losers: projects that look profitable on revenue but lost money on delivery hours. Without project-level COGS, founders chase top-line growth and discover too late that 30 percent of revenue comes from unprofitable projects. Set a minimum per-project gross margin (e.g., 50 percent) and decline work below it.
COGS optimization without quality loss
Three levers. One, productize repeat tasks: anything done more than twice should be templated, documented, and either automated or delegated to a lower-cost tier. Two, use AI for first drafts and research, then human review - cuts delivery hours by 30 to 60 percent for many tasks. Three, optimize the contractor stack: many US service firms use a mix of W-2 employees and 1099 contractors; periodically audit whether each role is in the right bucket. Avoid the trap of cutting COGS via cheaper offshore subcontractors without quality control - one bad delivery costs more than two years of savings.
FAQ
Are SaaS subscriptions COGS or OpEx?
Depends on use. SaaS tools used directly in delivery (CRM seats for sales-delivered services, design tools used on client work) are COGS. SaaS tools used for general operations (accounting, HR, marketing analytics) are OpEx. The cleanest test: would this subscription scale with the number of clients you serve? If yes (per-seat scaling), COGS. If no (fixed company-wide cost), OpEx. Mixed-use tools (e.g., HubSpot used for both sales and marketing) can be split if material.
Is owner labor part of COGS?
Yes if the owner does billable delivery work, in proportion to delivery hours. A founder who spends 60 percent of time on client delivery should have 60 percent of their imputed market salary in COGS, 40 percent in OpEx (admin, sales, leadership). Most US sole proprietors and S-Corp owners do not allocate this and end up with inflated gross margin. For internal management, impute a fair-market salary and allocate properly. For tax, follow the entity-specific rules; consult your CPA.
Should freight and shipping be in COGS?
Inbound freight (cost to receive raw materials or inventory): yes, COGS. Outbound shipping to customers: depends on accounting policy and whether it is included in product price or billed separately. Under US GAAP and IFRS, outbound shipping included in selling price is typically COGS. Outbound shipping billed as a separate line is sometimes recorded as a contra-revenue or in OpEx. Be consistent across periods; auditors will check.
How does COGS affect my tax bill?
COGS is deductible from gross revenue to arrive at gross profit, which then flows through to taxable income. Higher COGS lowers taxable income. The IRS does not allow you to manipulate categorization between years to time tax obligations - consistency is required. For inventory-based businesses, IRS rules under IRC Section 471 govern inventory accounting (FIFO, LIFO, weighted average); choice of method materially affects taxable income in periods of changing input prices.
What if my COGS percentage is rising?
Diagnose by sub-component. Is labor cost per delivery hour rising (wages, benefits, taxes)? Are subcontractor rates rising? Are tools becoming more expensive? Is scope creep eating unbilled hours? Most US service businesses see COGS percentage rise 1 to 3 percent per year due to wage inflation; offset with annual price increases of similar magnitude. Sharper increases (5+ percent year-over-year) usually indicate operational drift requiring intervention.
In your business
- →Be strict about what's in COGS - only direct delivery costs
- →For service businesses, COGS is mostly delivery labor - track it per project
- →Compare COGS as % of revenue over time - rising % means efficiency is declining