Tax Advice

Understanding Cost of Goods Sold for Services

There’s a lot of information on your financial statements and it can be easy to breeze right over some of the numbers. But one number you don’t want to miss: cost of goods sold (COGS).

This number is important and isn’t just a number that you need to know to fill out your tax return. This number tells you how much you make from what you sell and it can help you see if your pricing is right.

But what if you don’t sell “goods”? Can COGS still be of use to you? Here’s what every service business needs to understand about cost of goods sold for services.

What Is COGS?

COGS sounds like an abstract topic, but it’s pretty intuitive when you spend a little time defining it. Think of your expenses as falling into two categories:

1. Costs that are directly related to producing a product or delivering a service
2. Those that don’t directly relate to producing a product or delivering a service

That first category are your COGS, which are variable. If you don’t sell anything, you won’t have any COGS. You only have these expenses when you sell something.

Unlike COGS, operating expenses are indirect costs and don’t vary based on how much you sell. This includes things like rent, utilities, and marketing costs. No matter how much you sell, your rent won’t change.

If you’re looking at your expenses and you’re still not sure which would be classified as a COGS, there’s a simple way to work through it. Ask yourself, “Would you have to pay this expense whether or not you sold anything?” If you’d need to pay for it regardless, it’s probably not a COGS.

Why Is COGS Important?

There’s a lot to know when it comes to your financials, and you might be tempted to skip past a lot of it because you’re busy running a business. Taking time to sit down and calculate your COGS might fall to the bottom of your priority list.

Don’t skip past calculating and understanding your COGS. Here’s why:

It Can Be Used to Calculate Gross Profit Margin

An important KPI for small business owners to track is their gross profit margin and you just need two numbers to calculate it: revenue and COGS.

Your gross profit margin tells you how much money you have remaining after paying for the product that you sold. That gross profit margin needs to be high enough to cover all of your indirect expenses, like marketing and salaries. Tracking to see whether your gross profit margin increases or decreases over time can help you get a sense of the financial health of your business.

It Helps You Make Accurate Pricing Decisions

Getting pricing right is tough to do. Price it too high and you might have fewer customers. Price it too low and you’ll have trouble breaking even.

How do you know if you’re charging enough to cover your costs? Knowing your COGS can help. You’ll see exactly how much it costs to actually sell your product or service. As a result, you can estimate the volume you’ll need to sell to cover your other costs. If the amount you need to sell is unreasonably high, your price might be too low.

It Helps You to Separate Direct vs. Indirect Costs

There are expenses that you’ll have to pay each month regardless of whether you earn a dollar. These are your indirect costs. When you separate out your COGS, it makes it easy to see what your total indirect costs are.

It’s really important to have a handle on these expenses. Knowing what you’re on the hook to pay every single month will remind you of your break-even point—the amount of money you need to make to cover your costs.

It Can Help You See How Efficiently You Produce What You Sell

Over time, do you see your COGS increase and decrease in line with how much you sell? That will give you an indication of whether costs related to what you sell are increasing, decreasing or remaining the same. If your costs are increasing and your sales aren’t increasing, that might be something you want to investigate to find out why.

Can You Have Cost of Goods Sold for Services?

Yes, sometimes. According to the IRS, if you work in a personal service business and you sell or charge for the materials and supplies normally used in your business, you will have cost of goods sold for services to report on your tax return.

For example, a yoga studio that also sells yoga mats and apparel will have COGS related to the products that they sell. A hair salon that also sells shampoo and other products will have COGS related to those products.

But what if you only sell services and don’t sell products?

The IRS doesn’t include the cost of services separately, as it does with COGS. But it’s still a very important number to track and measure.

For example, your business is a marketing agency and one of your clients asks you to help with a new website launch. You accept the job but need to outsource some of the web design, so you hire a contract web designer. That cost should be included in your cost of services.

If the total cost of the project was $10,000 and you paid the contract web designer $3,000, your gross profit from the job will be $7,000. Keeping track of this can help you see if you’ve priced your services well and can help you keep a handle on the additional costs you’re incurring to serve your clients.

How Is COGS Calculated?

Calculating COGS isn’t difficult, but it does require you to keep accurate records, which is something a good accounting system can help you with. You’ll need to find a few numbers before you can dive into calculating your COGS.

The formula for calculating COGS is as follows, where “starting inventory” is inventory at the beginning of the year and “ending inventory” is inventory at the end of the year:

cost of goods sold = (starting inventory + purchases) – ending inventory

If you’re purchasing products to resell, this is a pretty straightforward calculation. You’ll use the dollar value of your inventory from the first day of the year, the amount you spent in purchases, and the dollar value of your inventory at the end of the year.

If you sell T-shirts and you had $5,000 in inventory at the beginning of the year, purchased $8,000 in inventory during the year, and had $4,000 remaining at the end of the year, your COGS is $9,000 ($5,000 + $8,000 – $4,000).

You may also have other costs included in COGS. For example, if you print logos on the T-shirts you sell, you’ll also have costs related to labor, printing materials and direct utilities. You might also have costs for shipping or any salesperson commissions. Remember, you’ll include any direct costs—costs you only incur because you’re selling an item.

On IRS tax form Schedule C, part 3 you’ll see a worksheet to help you calculate COGS. It includes spaces for cost of labor, materials and other expenses.

How to Report COGS in FreshBooks

Cost of goods sold allows you to classify expenses that are incurred on behalf of your client(s) as well as expense categories. Or, if you just want to log expenses for your business, you can use the steps here instead.

Marking expenses as COGS also ensures the expense is allocated correctly on the Profit & Loss report in the Cost of Goods Sold section under Income, even if the expense is never billed onto an invoice.

(If you’re looking to assign and rebill expenses so you can invoice them to your clients, you can find the steps here.)

How to mark an expense as COGS:

1. Go to the Expenses section.
2. Click on an existing Expense or the New Expense button and select Manually Create.
3. If editing an existing Expense, click the Edit button.
4. Click the Category field and scroll down till you see the Cost of Goods Sold section.
   
5. If you need to create a custom expense sub-category, type in the name of the new subcategory and click the Create button. Make sure to set the Expense Type to Cost of Goods Sold.
6. Click Save to finish.

The expense will now be categorized as COGS. It will also automatically reflect this in the COGS section on your Profit & Loss report.

Ready to Know Your Cost of Goods Sold for Services?

COGS isn’t just a line item that you need to fill out on your tax return. It’s an important financial metric that can help you analyze your business, understand your costs, and make decisions. Whether you’re a product business or a service business, this is a number you’ll want to know.

This post was updated in August 2022.