What is the purpose and need to calculate COGS in accounting?

Accounting Basics
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purpose of COGS

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COGS stands for Cost of Goods Sold. In simple terms, it is the total direct cost a business incurs to produce or procure the goods it actually sells during a given period.

Not all costs are considered COGS. Just the ones directly tied to making or buying the product that is left on your shelf.

To understand better, we’ll take an example

You opened a juice stall. You earned ₹3,000 today. But you spent ₹1,200 on fruits, ₹300 on cups and straws, and paid your helper ₹400 for the day. That ₹1,900 in direct costs. That is your COGS. And knowing it tells you that your actual gross profit for the day was ₹1,100 not ₹3,000.

That’s what COGS shows. It deducts the confusions by the revenue and shows you what the business actually earned after covering what it cost to run.

The formula is:

COGS = Opening Stock + Purchases During the Period − Closing Stock

So, a question must come to your mind, why does this number matter? Why do accountants, investors, founders, and tax authorities all care about it?

Let’s break it down properly.

Before getting into the purpose, we will have to understand what actually goes into this number, because people often confuse it with total business expenses.

What is included in COGS:

  • Raw materials used in production

  • Direct labor - the workers actually making the product

  • Manufacturing costs directly linked to production

  • Purchase cost of goods bought for resale (for trading businesses)

What is NOT included:

  • Office rent

  • Marketing and advertising spend

  • Salaries of admin or management staff

  • Legal or accounting fees

The simple test to know if the expense is COGS is if that cost disappears when you stop producing the product, it’s likely COGS. If it exists regardless of production, it’s an operating expense.

Why do we calculate it?

There are various reasons as to why it is necessary to calculate COGS. Some of them enlisted below are

1. To find out of the business is actually profitable at Its core

Revenue numbers can be deeply misleading on their own. A business could be pulling in ₹50 lakh a month in sales and still be in serious trouble, if it costs ₹47 lakh to produce what it’s selling.

This is where COGS comes in:

Gross Profit = revenue − COGS

Gross profit tells you how much money is left after covering the direct cost of what you sold. It is the first and most fundamental measure of whether a business is financially healthy at its core, before even touching operating expenses, taxes, or loan repayments.

Without calculating COGS, we simply cannot calculate gross profit. And without gross profit, we will be working with incomplete financial information.

2. To price products intelligently

Pricing isn’t guesswork - COGS is where every decision begins.

  • Price below your production cost and you can’t survive

  • Without per-unit COGS, there’s no rational basis for your price

  • You could be selling more while losing more, without realising it

For any business, COGS is the floor no price can go below and still make sense.

Per unit COGS - The total cost to produce one single unit - materials, labor, packaging, and any other direct production costs added together.

For example: ₹50 (materials) + ₹30 (labor) + ₹20 (packaging) = ₹100 per unit COGS.

3. To stay on top of inventory

Calculating COGS isn’t just a profit exercise, it’s an inventory exercise too. To even arrive at the COGS figure, a business must know:

  • What stock it had at the start of the period

  • What it purchased or produced during the period

  • What stock remains at the end

This forces systematic inventory tracking. As a result, the business always knows what it has, what it has sold, and what needs to be replenished. Poor inventory management leads to overstocking, wastage, and cash getting stuck, all of which COGS tracking helps prevent.

4. To calculate and manage taxes correctly

COGS is a legitimate, deductible business expense. Under Section 28 of the Income tax act, 1961, a business is taxed on its profit, not its revenue. And profit is only arrived at after subtracting COGS.

Section 28 in The Income Tax Act, 1961

This means:

  • Accurately calculating COGS reduces taxable income legally and correctly

  • Overstating COGS means underpaying tax , which is a legal risk

  • Understating COGS means overpaying tax, which is just unnecessary loss of money

Getting COGS right is therefore not just good accounting practice - it directly affects how much tax a business pays.

5. To catch operational problems early

Tracked consistently over time, COGS tells a story about how efficiently the business is operating.

  • COGS rising while revenue stays flat? Raw material costs or wastage may be climbing

  • Sudden spike in COGS? Could be supplier hikes, theft, or production inefficiency

  • COGS falling as a percentage of revenue? The business is scaling efficiently

Without regular tracking, problems stay invisible until they’re serious. COGS is an early warning system for operations.

6. To build credibility with investors and lenders

Any investor or bank evaluating a business will look at gross margin, which is calculated directly from COGS:

Gross Margin % = (Revenue − COGS) ÷ Revenue × 100

A healthy, consistent gross margin signals that the business has control over its production costs and has a fundamentally sound model.

A founder or business owner who cannot explain their COGS clearly will lose credibility immediately in any serious financial conversation.

7. To budget and plan for the future

Historical COGS data is one of the most important inputs for financial forecasting. When planning for the next quarter or year, businesses use past COGS figures to:

  • Estimate future production costs

  • Model profitability at different sales volumes

  • Set realistic revenue and margin targets

  • Evaluate whether scaling up will actually improve or hurt margins

Without reliable COGS data, financial planning has no solid foundation to stand on.