How to Calculate Cost of Goods Sold (COGS) for a Small Business

By Syed M. Tahir · Published 2026-11-02 · 8 min read

Cost of goods sold, usually shortened to COGS, is the cost of the products you actually sold during a period. It is one of the most important numbers in a product business. It turns sales into gross profit, it tells you whether your prices really cover what you make or buy, and in many countries it is a line on your tax return. Yet many small sellers never calculate it properly. They either count every purchase as a cost the moment they pay for it, or they guess. This guide explains the standard formula, what belongs in COGS and what does not, and how to work it out for a small or handmade shop. US tax rules are summarised from the IRS publications linked at the end. Rules differ between countries and change over time, so check with your own tax authority or an accountant before filing.

The cost of goods sold formula

COGS is not simply what you spent on stock this year. Some of what you bought is still on the shelf, and some of what you sold was bought last year. The formula takes care of both:

COGS = beginning inventory + purchases and production costs − ending inventory

Beginning inventory is the value of the stock and materials you had at the start of the period. You then add everything you bought or spent to make products during the period. Whatever is left at the end, the ending inventory, has not been sold yet, so it is subtracted. What remains is the cost of the goods that left your business.

The IRS uses exactly this structure in Part III of Schedule C, the form many US sole proprietors use to report business income. It lists inventory at the beginning of the year, purchases (less the cost of items you withdrew for personal use), cost of labour (not including any amounts paid to yourself), materials and supplies, and other costs. These are added together, the inventory at the end of the year is subtracted, and the result is cost of goods sold, which is then carried to the income section of the form.

What to include in COGS

COGS covers the direct costs of getting products ready to sell. For a typical small product business, that means:

• Stock bought for resale, including the shipping you paid to have it delivered to you.
• Raw materials and parts that become part of the product, such as leather, fabric, wax, beads, yarn, wood or ink.
• Packaging that is part of the product, such as a jar, a gift box or a printed label.
• Direct labour you pay others to make the product, such as a part-time helper paid per piece. In the US, Schedule C asks you not to include amounts you pay yourself.
• Other direct production costs, such as outsourced printing or finishing work for specific products.

What usually does not belong in COGS

Many business expenses are real costs but not costs of the goods themselves. These are normally reported as operating expenses instead:

• Marketplace and payment processing fees, such as Etsy transaction and processing fees
• Advertising and promotion
• Postage to send orders to customers, which is usually treated as a shipping or selling expense
• Website, software and subscription costs
• General office supplies, phone and internet
• Your own time, if you are a sole proprietor

The split matters because it changes what your gross profit tells you. Gross profit (sales minus COGS) shows whether your products are priced well above what they cost to make. Operating expenses then show how much of that gross profit the rest of the business uses. If you mix the two, it becomes hard to see which part needs fixing.

Step by step: calculating COGS for a year

1. Count your stock at the start. Use the ending inventory figure from the previous year. If this is your first year, beginning inventory is usually zero, or the cost of any stock you put into the business when you started.
2. Total your purchases. Add up stock and materials bought during the year, using your receipts and bank records. Subtract anything you took out for personal use or gave away as personal gifts.
3. Add direct labour and other production costs paid to other people.
4. Count your stock at the end. Do a physical count of finished products, work in progress and raw materials on the last day of the period, and value them, usually at what they cost you.
5. Apply the formula. Beginning inventory plus purchases and production costs, minus ending inventory.

Worked example: a small leather goods shop

Suppose a maker starts the year with leather, hardware and finished bags that cost 1,200. During the year they buy 6,500 of materials, including delivery to their workshop, and pay a helper 900 to stitch some bags. They took home a bag with materials worth 100 for personal use. At the end of the year, a stock count shows materials and finished bags that cost 1,600.

• Beginning inventory: 1,200
• Purchases less personal use: 6,500 − 100 = 6,400
• Cost of labour: 900
• Total available: 1,200 + 6,400 + 900 = 8,500
• Less ending inventory: 8,500 − 1,600 = 6,900 cost of goods sold

If the shop's sales for the year were 18,000, gross profit is 18,000 − 6,900 = 11,100, a gross margin of about 61.7%. Fees, advertising and other expenses then come out of that 11,100. Our profit margin calculator converts any cost and price into margin and markup if you want to check individual products.

Valuing inventory

Ending inventory is usually valued at cost: what you paid for the materials and stock still on hand. On Schedule C, the IRS asks which method you used to value closing inventory, with the options of cost, lower of cost or market, or another method. If you buy the same material at different prices during the year, you also need a consistent way to decide which purchases are still in stock. IRS Publication 334 and Publication 538 explain the accepted identification methods, such as first in, first out (FIFO). Whatever method you choose, use it consistently from year to year, because changing it can affect your taxable income.

The IRS also explains that some small businesses that meet a gross receipts test can choose a simpler approach instead of keeping formal inventories, such as treating inventory as non-incidental materials and supplies. Whether that applies to you, and how it works, is a question for Publication 334 or a tax professional. The point for everyday management is the same: you still need to know what your products cost.

Cost per unit: the number you use every day

Annual COGS is a backward-looking total. For pricing, you also need the cost of one unit. Divide the cost of the materials and labour that go into a batch by the number of items it makes. If a hide costing 180 yields six bags, and each bag also uses 12 of hardware and lining, the materials cost per bag is 180 ÷ 6 + 12 = 42. That per-unit cost is what you enter in the product pricing calculator to build a retail and wholesale price, and in the break-even calculator as the variable cost per unit, together with packaging and postage, to see how many sales you need to cover your fixed costs.

Common mistakes

• Treating all purchases as COGS. If you buy a year's worth of materials in December, your COGS is overstated for that year and understated the next unless you count closing stock.
• Skipping the stock count. Without an actual count, ending inventory is a guess, and so is COGS.
• Forgetting inbound shipping. Delivery charges for materials are part of what the materials cost you.
• Mixing personal and business items. Remove anything you keep, use or give away personally.
• Putting fees and advertising in COGS. They are real costs, but they belong in expenses, so your gross margin stays meaningful.

Keep good records

COGS is only as reliable as the records behind it. Keep receipts and invoices for every material purchase, note the date and quantity, and record your stock count at the end of each year. IRS Publication 583 sets out the kinds of records a US business is expected to keep and for how long. A simple spreadsheet with one row per purchase and a yearly stock sheet is enough for most small shops. For the bigger picture of costs and pricing, read our guides to pricing handmade products and break-even analysis, and if you sell on Etsy in the US, our guide to the Etsy 1099-K form explains how your gross sales are reported. IRS references in this guide were last checked on 2 November 2026.

Sources

• IRS – Instructions for Schedule C (Form 1040), Part III Cost of Goods Sold
• IRS Publication 334, Tax Guide for Small Business (chapter 6: How To Figure Cost of Goods Sold)
• IRS Publication 538, Accounting Periods and Methods
• IRS Publication 583, Starting a Business and Keeping Records

This guide is general information and is not tax, accounting or legal advice. Tax rules differ between countries and change over time; check your tax authority's current guidance or ask a qualified professional. DailyToolLab is not affiliated with the IRS, Etsy Inc., Shopify Inc. or eBay Inc.