What is Cost of Goods Sold?

Cost of goods sold is how much it costs to make a product or service. Gross profit is revenue less cost of goods sold.

Cost of goods sold includes the direct costs involved with making a product or service including:

• payroll for team members
• software and/or materials

Operating expenses like Sales, HR/People Ops and R&D are indirect costs that are excluded from COGS.

Why is Cost of Goods Sold important?

The selling price of a product or service has to be higher than your cost to make and sell it. The higher COGs are, the lower the margin is.

Gross profit excludes sales and marketing functions so is an incomplete measure of business viability. When evaluating a business, we want to understand the gap between revenue and COGs and whether there's enough margin to cover customer acquisition cost (CAC) and make a profit.

Many companies bet on their ability to improve gross margin over time with economies of scale. For early stage startups, it's important to understand the unit cost, or the COGs on a per-unit basis. If the unit cost is too high in the short term, a startup may run out of money before they're able to benefit from economies of scale.

While a company's revenue may look incredible, if they're spending more to make and sell the product/service than they're able to charge for it, there could be trouble down the line. Reviewing COGs line by line could help the company understand where there's opportunity for better efficiency.

FAQs

How is cost of goods sold calculated?

Costs of goods sold is calculated by adding together all costs and expenses incurred in producing a product or service.

How cost of goods sold is calculated varies based on the accounting standards a company uses and the industry the company is in.

What is an example of cost of goods sold?

A vertically integrated company that sells a flower subscription for $100 per month spends $70 on fertilizer, seeds, land to grow the flowers, the florist's salary and delivery to the customer. They have 30% gross margins at scale. As an investor, we want to understand how many subscriptions they have to sell to achieve scale, what's the churn rate, what's the cost of customer acquisition, what assumptions are made about leftover inventory (is this assuming a 100% sell through rate?) etc.

Related resources

• Elizabeth Yin on Unit Economics
• Why Revenue isn't the Most Important Metric for a Startup, Tomas Tunguz
• Gross Margin, Baremetrics