What is Cost of Goods Sold (COGS)?

Cost of Goods Sold, commonly referred to as COGS, is a critical financial metric that tracks the direct costs attributable to the production of the goods sold by a company. It answers a simple but vital question.

How much does it cost you to deliver your product to a customer?

This is not about the cost of running the business. This is about the cost of the item itself. If you stop selling products today, these costs should theoretically drop to zero. For a physical product, this is intuitive. It is the cost of the raw materials and the labor required to assemble them.

However, for startups in the service or software sectors, defining COGS can be murkier. Yet, getting this number right is essential because it is the baseline for your gross margin. If your COGS is too high, no amount of sales volume will make your business profitable.

To calculate this metric accurately, you must strip away all the general overhead of the business and look only at direct inputs. Generally, COGS consists of two main categories.

Direct Materials: The raw components that go into the final product. If you manufacture bicycles, this is the metal, the rubber tires, and the paint.

Direct Labor: The wages of the specific employees who manufacture the product. This includes the assembly line worker, but it typically excludes the manager who oversees the factory floor.

The confusion for many founders lies in distinguishing between COGS and Operating Expenses, or OpEx.

OpEx includes the costs of running the company that do not fluctuate directly with production volume. Rent, marketing spend, administrative salaries, and research and development are all OpEx. You have to pay the rent whether you sell one unit or one million units.

COGS is variable. If you sell twice as many bicycles, your cost of metal and rubber doubles. The distinction is vital for understanding scalability. A business with high OpEx but low COGS has high operating leverage. Once they cover their fixed costs, every additional dollar of revenue is mostly profit.

For software startups, there are no physical parts. However, COGS still exists and is scrutinized by investors.

In a SaaS environment, COGS typically includes:

• Hosting Fees: The money paid to AWS, Google Cloud, or Azure to serve the application to the user.
• Third-Party Licenses: Fees for embedded software required for your product to function.
• Customer Support: In many models, the support team is considered a direct cost of delivering the service.

If your software is inefficient and requires massive server power to run, your COGS will be high. This suppresses your gross margin and lowers the valuation of the company.

Founders must obsess over this number because it dictates your pricing floor. You cannot price your product below your COGS and survive. More importantly, it dictates your unit economics.

When you hear investors talk about “gross margin,” they are mathematically talking about Revenue minus COGS. If you have a low gross margin because of high COGS, you have less money left over to spend on marketing and growth. Minimizing these direct costs is often the fastest way to improve the financial health of a startup.