How to write the perfect COGS formula for your financial model

If you’re running a startup, you’re likely handling more than one role at the same time. Beyond building the product or serving customers, you may also be the person responsible for tracking the numbers. When that’s the case, understanding your financial metrics becomes essential — starting with your cost of goods sold, or the COGS formula.

Now, you don’t need to sweat over spreadsheets and numbers. This guide breaks down the COGS formula in a clear, practical way that’s easy to apply to your business. Once your financial model is built on accurate inputs, it becomes much easier to make confident decisions, understand your margins, and focus your energy on growing the company.

Key takeaways 

• COGS directly impacts gross profit by capturing the true cost of producing your product or service

• Core components include direct materials, direct labor, and production-related overhead

• Proper cost allocation clarifies product-level profitability and pricing decisions

• Accurate tracking depends on clearly defined direct costs, clean data, and reliable systems

• Inventory accounting choices (FIFO, LIFO, weighted average) affect how costs flow through financials

• Clear cost visibility strengthens budgeting, compliance, investor trust, and long-term financial modeling

Table of contents

• What does cost of goods sold (COGS) mean?
• How to write the perfect COGS formula
• Why the COGS formula matters for startups
• Different methods for calculating COGS
• Choosing the right method
• FAQs

What does cost of goods sold (COGS) mean?

Cost of goods sold is the cost of running your business. It covers everything that is directly involved in product formation, such as raw materials, labor, and production costs. At first, subtracting COGS from revenue might seem like simple math. But it’s actually a big deal. This number gives you your gross profit, which helps in your startup’s financial decisions.

It helps you see your real profits after covering production costs. It shows how much you’re actually spending to make, ship, and deliver your products to your customers’ hands. 

What are the components of cost of goods sold? 

Here, I’m breaking down the COGS components to help you understand what to include and how to allocate these costs correctly. And these primary elements include:

1. Direct materials: These are the basic supplies that are needed to make a product. 
   If you build furniture, this includes wood, nails, and varnish. These materials turn into a strong, stylish chair. Tracking these costs is important for keeping your business running smoothly. If you ignore them, profits can sink fast. But if you manage them well, your business stays on course.
2. Direct labor: This covers wages for employees who work directly on your product. In a software company, this includes the salaries of developers who code your next big idea.  Just like you wouldn’t count the cook’s wages when building a ship, you shouldn’t include managers or executives in direct labor costs. Focus only on the people who are hands-on with production, not the folks steering from the captain’s deck.
3. Manufacturing overhead: These are the necessary but indirect costs that help keep your production line running smoothly. They include utilities, maintenance, and the cost of equipment wearing out over time (depreciation). While they don’t directly relate to a specific product, they ensure that everything continues to run efficiently, even if they’re not immediately visible.

How to write the perfect COGS formula

Before we start counting the numbers, let’s take a step back and review the basics of COGS. Understanding why this  formula matters and how it works is just as important as the actual calculations. When you know the purpose and process, the numbers will make a lot more sense.

Step 1: Identify direct costs

The first step in calculating cost of goods sold is finding all the direct costs of product formation. These are expenses that come directly from the production process. These usually include three key things: materials, labor, and overhead.

• Materials are what you use to create the product. 
• Labor covers the wages of workers who build or assemble it. 
• Overhead includes factory costs like utilities and equipment maintenance.

Step 2: Gather accurate data

The perfect COGS calculation needs accurate data. That means keeping your records clean and tracking every direct cost down to the last penny. No rounding up or guessing - because only precision matters. Good bookkeeping is the secret to getting it right. Unless you're a big fan of old-school pen and paper, using reliable accounting software is a smart move.

• Inventory management: Let’s suppose that your inventory is like a fridge that is full of tasty leftovers. But instead of food, you’re managing raw materials and finished goods. Because keeping track of what comes in and what goes out is key. A good inventory management system makes this much easier - you need to trust the experts on that. 
  Always monitor your beginning and ending inventory levels. This helps you stay organized and avoid sudden surprises. Just like a fridge, a well-managed inventory keeps everything fresh and ready to use.
• Expense tracking: Accounting software makes tracking your expenses easy. It helps you record and organize every cost without hassle. Plus, it makes spotting direct costs for your COGS super simple. 

Step 3: Calculate direct materials costs

As mentioned above, direct materials costs are the expenses for raw materials used in production during a specific period. To calculate these costs, you can use this simple formula: 

Beginning inventory + Purchases - Ending inventory = Direct materials cost.

To determine the beginning inventory, you can start by identifying the value of the raw materials inventory at the start of the accounting period. After that, add the cost of raw materials purchased during the period. Lastly, subtract the value of the raw materials inventory at the end of the period.

Step 4: Calculate direct labor costs

Direct labor costs are the wages paid to workers who help make a product. You can figure out these costs with a simple formula:

Direct labor hours × Hourly wage = Direct labor costs

Track the time your employees work on your products or services to find your direct labor hours. Once you have the total hours, multiply them by each employee’s hourly wage. This gives you the direct labor cost.

Step 5: Include manufacturing overhead

Manufacturing overhead covers all the indirect costs that keep production running. Getting these costs right is key to an accurate calculation. Start by listing every indirect cost linked to production. This includes utilities, equipment wear and tear, and maintenance. These behind-the-scenes expenses are just as important as direct materials and labor. Once you’ve identified them, it’s time to divide them fairly. Use a consistent method like machine hours or labor hours.

Step 6: Assemble the COGS formula

When you're finished calculating direct materials costs, direct labor costs, and manufacturing overhead, you can assemble the COGS formula. This final calculation helps you see the total cost of producing your goods within a specific time frame. It might look something like this:

COGS = Beginning inventory + Purchases - Ending inventory + Direct labor cost + Manufacturing overhead

COGS formula example

Let's break it down with a simple example to see how these pieces work together.

1. Beginning inventory: $10,000
2. Purchases: $5,500
3. Ending inventory: $3,000

Using the formula:

COGS = $10,000 + $5,500 − $3,000 = $12,500 

And there we have it. The total cost of goods sold for this period is $12,500.

Why the COGS formula matters for startups? 

If you've made it this far, you probably get why these calculations are so important, especially if you're managing a startup. Here's how you can use the COGS formula to connect day-to-day operations with real financial outcomes.

Accurate profitability assessment

The formula helps you see exactly what it costs to make your goods. This makes it easier to check your gross profit, which is your revenue minus direct costs. When COGS is lower compared to revenue, your gross margin is higher. A higher gross margin means better profits and a stronger business. The more gross profit you have, the easier it is to cover expenses. This also helps your startup generate more net profit over time.

For example, if your startup generates $100,000 in revenue and has a COGS of $40,000, it will have $60,000 to cover operating expenses and net profit. This amount is what’s available to cover other costs (like marketing, salaries, and rent) and, ultimately, generate profit. For startups, where every dollar counts, understanding key numbers like your gross profit can make the difference between growth and stagnation.

Informed pricing strategies

With a solid understanding of your COGS, you can avoid underpricing (which could lead to losses) or overpricing (which might scare away customers). The goal is to find a price that keeps you competitive while protecting your profits.

Startups often operate in highly competitive markets, and knowing your COGS allows you to price your products strategically to maintain both customer appeal and profitability. Startups often face tough competition, so smart pricing is key. When you understand your costs, you can set prices that attract buyers and keep your business strong.

For instance, if it costs $30 to produce a product and you sell it for $50, you preserve enough margin to support operations while staying competitive. This kind of clarity helps startups scale without unintentionally pricing themselves into a corner.

Financial planning and budgeting

Accurate COGS calculations play a significant role in financial planning and budgeting. It helps you see exactly what it costs to produce your goods and makes it easier to manage cash flow. With accurate COGS, you can plan ahead and ensure you have enough money for production and other expenses. Furthermore, understanding your cost of goods sold lets you budget smarter. You can spot areas where you can cut or optimize costs, which lets you manage your resources more efficiently.

For example, if you find that manufacturing overhead is disproportionately high, you might explore investing in more efficient equipment or renegotiating supplier contracts to reduce costs.

Better inventory management

Keeping track of your inventory is key to calculating COGS accurately. It helps you stay on top of stock levels and avoid costly mistakes. When you understand your COGS, you can prevent overstocking and stockouts. This way, you can keep the perfect balance, save money and reduce waste.

Tracking how costs move through your inventory helps you spot production issues. You can negotiate bulk deals if your cost of goods sold (COGS) is high because of frequent small-batch purchases. But buying larger quantities will lower your per-unit cost and boost your profit.

Compliance and reporting

Another critical reason for accurate COGS calculation is that it helps you stay compliant with financial and tax regulations. If you mess up, you could face penalties from tax authorities. That’s not something you want to deal with.

Also, being upfront in your financial reports, especially about cost of goods sold, goes a long way in earning investors' trust. They want to see exactly what your costs and profits look like before deciding to back you. Detailed reports that break down your COGS show that you’re reliable and serious. This makes it easier to attract the funding you need to grow.

Different methods for calculating COGS

There are three main methods: FIFO (First-in, First-out), LIFO (Last-in, First-out), and Weighted average cost. Each method follows a different rule for deciding which items are sold first.

1. FIFO (First-in, First-out)

FIFO works by selling the oldest inventory first. This means the cost of the first items purchased is used to calculate COGS.

Implications:

• Higher profits during inflation: During inflation, businesses can make higher profits with FIFO. This method uses older, cheaper inventory costs when calculating expenses. As a result, the cost of goods sold (COGS) stays lower while revenue stays high. This leads to bigger profits and higher taxable income.
• More accurate inventory valuation: The balance sheet shows a more accurate market value because newer and more expensive items stay in inventory. This helps reflect current prices and gives a clearer financial picture.

For example: Let’s say your startup sells artisanal candles. You bought 100 candles for $10 each in January. Then, you got another 100 candles for $12 each in June. Now, if you sell 150 candles by the end of the year, FIFO (First-in, First-out) means you sell the oldest stock first. So, your cost of goods sold (COGS) would be:

100 candles × $10 = $1,000

50 candles × $12 = $600

Total COGS = $1,600

FIFO makes it easy to track costs. You always sell the earliest inventory first. 

2. LIFO (Last-in, First-out)

LIFO means the newest inventory gets sold first. This means the cost of the latest purchased items is used to calculate COGS.

Implications:

• Lower profits during inflation: In times of rising prices, LIFO results in higher COGS because it matches newer, higher costs against current revenues, leading to lower gross profit and taxable income.
• Tax benefits: Lower taxable income can be beneficial for tax purposes, but it may also lower reported profits, which could affect investor perception.

Example: Using the same candle business scenario, under LIFO, if you sell 150 candles by year-end, your COGS will be:

100 × $12 + 50 × $10 = $1,200 + $500 = $1,700

3. Weighted average cost

The weighted average cost method averages out the cost of all inventory items available for sale during the period and assigns this average cost to each unit sold.

Implications:

• Smooth cost fluctuations: This method smooths out price fluctuations over the accounting period, providing a more consistent COGS.
• Simplified inventory management: It's easier to apply and manage compared to FIFO and LIFO, especially when inventory prices vary significantly.

Example: In the candle business example, the weighted average cost per candle is: 

[(100 × $10) + (100 × $12)] / 200 = ($1,000 + $1,200) / 200 = $11 per candle. 

If you sell 150 candles at this average cost, your COGS will be:

150 × $11 = $1,650. 

Choosing the right method

When selecting the best method for calculating COGS, you'll need to consider several factors. But first, make sure that it aligns with your financial goals and operational needs. 

1. If your mind is on financial reporting goals and your priority is to report higher profits and maintain an accurate inventory value, the FIFO (First-in, First-out) method may be the best choice. On the other hand, if minimizing taxable income is a key objective, LIFO (Last-in, First-out) could provide an advantage.
2. Economic conditions also affect this decision. For example, FIFO increases taxable income in times of inflation because older, lower-cost inventory is sold first. While LIFO reduces taxable income by selling higher-cost inventory first. Industry practices are another key factor.
3. After that, tax regulations in your area can also play a big role. In the U.S., LIFO is allowed for tax purposes, but in many other countries, it’s not. Places that follow International Financial Reporting Standards (IFRS) don’t permit LIFO, so if you're operating internationally or dealing with global investors, it’s important to stay up to date on local requirements for accurate reporting.

Pro tip: Using methods that are standard in your field keeps things consistent, makes it easier to compare your business to competitors, and shows investors you’re on top of your game.

Make better decisions with the COGS formula

When startup decisions start to feel complex, understanding your cost structure gives you clarity. The COGS formula provides a practical way to see what it truly costs to deliver your product or service, helping you make better pricing and operational decisions. When this information feeds into your financial model, it becomes much easier to see how changes in costs affect margins and long-term sustainability.

At a higher level, cost visibility is essential to maintaining the financial health of your startup. By reviewing these numbers regularly and keeping your financial model up to date, you can spot inefficiencies early, plan with more confidence, and make decisions that support sustainable growth.

With a clear view of your costs and a well-built financial model, you’re better equipped to manage expenses, adapt as you scale, and build a business that can grow without surprises.