Analyzing Cost of Goods Sold (COGS) for Startups

When you're building a startup, one of the most important numbers you need to understand is your Cost of Goods Sold (COGS). It's more than just a line item on your income statement—it’s a key to understanding your business’s profitability.

COGS represents all the direct costs involved in producing your product or delivering your service. Whether you’re manufacturing physical goods or providing a service, knowing your COGS helps you price correctly, manage resources, and ultimately, improve your bottom line. 

I will help you understand what is Cost of Goods Sold (COGS) and how to analyze it to aid in your start-up's financial health

This guide breaks down everything a startup founder needs to know about COGS—from understanding its components to optimizing it for better margins.

Whether you’re a seasoned founder or just starting out, mastering COGS is essential for scaling your startup efficiently.

1. Understanding the Basics - What is COGS and Why Does It Matter?

What is COGS?

COGS (Cost of Goods Sold) is basically what it costs you to produce your product or deliver your service. It includes all the direct costs like materials and labor.

If you're selling physical products, it’s the cost of everything from raw materials to the work needed to assemble the product.

If you’re in a service business, it’s about what it costs to deliver your service, mainly labor and necessary tools.

Why COGS matters for startups

For startups, COGS is super important because it affects your bottom line. It tells you how much of your revenue goes into making what you sell. This directly impacts your gross profit—the difference between what you earn and what it costs to produce. 

The lower your COGS, the more profit you keep. Investors also care about this number because it shows if your business can be profitable and scalable.

COGS vs. Operating Expenses

One common mix-up is between COGS and operating expenses.

The key difference? COGS is what it costs to make your product or service, while operating expenses are the costs of running the business, like rent, salaries of your admin team, or marketing costs.

Keeping these separate makes your financials clearer and helps in calculating accurate profits.

2. Components of COGS for Product-Based Startups

Raw materials and supplies

If your startup sells physical products, raw materials are a major part of your COGS. These are the parts or ingredients you need to make the product—like fabric for clothing or components for electronics. 

These costs can change over time, so keeping a close eye on your suppliers and their pricing is crucial for managing your COGS effectively.

Labor costs

Labor costs are another significant piece of COGS. For product-based startups, this means the wages of the workers who physically make the product. 

If you’re running a small operation, this might be your factory workers or production team. 

Remember, this only includes labor directly involved in production, not your entire staff.

Manufacturing overhead

Manufacturing overhead covers the less obvious costs related to production. This can be the cost of running machines, utility bills for your production space, or equipment maintenance. 

These are all part of what it takes to make your product, so they’re included in COGS even though they don’t involve raw materials or labor directly.

3. Components of COGS for Service-Based Startups

Direct labor in services

For service startups, COGS doesn’t include raw materials—it’s mainly about direct labor. This refers to the people who are actively delivering your service. 

For example, if you run a digital agency, the work done by your designers or strategists on client projects would fall under COGS, as their work directly contributes to the service.

Software and tools

In service startups, the tools you use can also be part of your COGS. If you rely on specific software or platforms to deliver your service (like CRM systems or design software), the costs of these tools should be counted as part of your COGS since they’re essential to what you deliver to your clients.

Project-based expenses

You may also have project-specific costs that fall under COGS. 

For example, if you hire a freelancer to help with a client project or need special software for a particular task, these costs go directly into delivering that service and should be included in your COGS calculation.

4. How to Calculate COGS - A Step-by-Step Approach

Start with direct costs

The first step in calculating COGS is listing out all your direct costs. If you’re making a physical product, that means raw materials, direct labor, and manufacturing expenses. 

For service businesses, this could be the cost of the employees working on a project, plus any tools or software required to deliver that service.

Exclude indirect costs

It’s important to remember what not to include in COGS. Office rent, salaries for management, and marketing expenses are all indirect costs and belong under operating expenses, not COGS. 

These are expenses necessary to run the business but not directly tied to producing the product or service.

Account for inventory changes

If you’re selling physical goods, inventory plays a role in calculating COGS. You need to factor in the opening inventory (what you already have in stock), add any purchases, and then subtract the closing inventory (what’s left over at the end of the period). 

This way, your COGS reflects what you actually used to make and sell your products.

5. COGS Formula for Startups - Simplifying the Math

COGS formula breakdown

The COGS formula is pretty straightforward:

COGS = Beginning Inventory + Purchases – Ending Inventory

Let’s break it down. Beginning inventory is what you had at the start. Purchases include any new materials or stock you’ve bought. Ending inventory is what’s left at the end of the period. 

This formula gives you the total cost of what you sold during that time.

Real-world example

Let’s say you run a small clothing startup. You start the month with ₹1,00,000 worth of fabric (your beginning inventory), you buy ₹50,000 more in materials, and by the end of the month, you have ₹30,000 left in fabric. 

Using the formula: COGS = ₹1,00,000 + ₹50,000 – ₹30,000 = ₹1,20,000 This ₹1,20,000 is your COGS for the month.

Automating COGS tracking

You don’t have to manually calculate COGS each time. Accounting software like QuickBooks, Zoho Books, or Xero can automatically track your inventory and purchases, making it much easier to keep tabs on your COGS. 

These tools can also help you avoid mistakes that might come from manual tracking.

6. How COGS Impacts Startup Financials

COGS and gross profit

Your gross profit is the difference between your revenue and your COGS. The lower your COGS, the higher your gross profit. 

For example, if you sold ₹5,00,000 worth of goods and your COGS is ₹2,00,000, your gross profit is ₹3,00,000. This is a key measure of how efficiently you’re producing your goods or services.

Effect on pricing strategy

Knowing your COGS is critical for pricing your products or services. You need to price high enough to cover your COGS and still leave room for a profit. 

For example, if it costs ₹500 to make a product, you should price it well above that to cover both COGS and other operating costs while ensuring you make a healthy profit.

Tax implications of COGS

Here’s a bonus: COGS is deductible when calculating taxable income. This means the higher your COGS, the lower your taxable income, which can reduce your overall tax bill. 

Of course, this doesn’t mean you should inflate your COGS, but it’s a useful tool to be aware of when thinking about your tax strategy.

7. Optimizing COGS for Better Margins

Streamlining production

To improve your margins, you need to lower your COGS without sacrificing quality. One way is by streamlining production. This could mean finding faster or more efficient ways to manufacture your product. 

For example, automating part of your production process can cut labor costs or reduce errors, which saves money.

Negotiating with suppliers

Another way to optimize COGS is by negotiating better deals with your suppliers. 

If you’re buying raw materials, see if you can buy in bulk for a discount or negotiate longer payment terms. 

For service businesses, this might mean getting better rates on the software or tools you use regularly.

Outsourcing vs. in-house

Deciding whether to outsource production or keep it in-house is another big factor. 

Outsourcing can sometimes reduce costs if the external provider is more efficient or operates in a cheaper location. 

However, in-house production offers more control over quality and can lead to better long-term savings once you scale. Weigh these options carefully based on your startup’s needs.

8. Common COGS Mistakes Startups Make

Confusing COGS with operating expenses

One of the biggest mistakes startups make is mixing up COGS with operating expenses. If you put things like rent, office supplies, or marketing costs into COGS, it will throw off your calculations and make your financials inaccurate. 

Remember: COGS only includes costs directly tied to producing your product or delivering your service.

Not factoring in inventory properly

For product-based startups, not adjusting COGS for changes in inventory is another common mistake. 

If you don’t account for inventory properly (beginning inventory, purchases, and ending inventory), your COGS won’t reflect what you actually used to make your products. 

This can mess with your gross profit calculations and give you a skewed view of your financials.

Overestimating labor costs

In startups, employees often wear multiple hats. It’s easy to overestimate how much of their time is spent on production or service delivery versus other tasks. 

For example, if your lead developer spends half their time on management and the other half coding, only the coding part should go into COGS. 

Overestimating labor can inflate your COGS and reduce your margins on paper.

9. Tools and Software to Track COGS for Startups

Accounting software

Manually calculating COGS can be a headache, especially as your startup grows. That’s where accounting software comes in. 

Tools like QuickBooks, Xero, and Zoho Books can help automate COGS tracking by integrating with your inventory and purchase data. 

These platforms automatically update your COGS as you buy, use, and sell products.

Inventory management tools

For product-based startups, inventory management is key. Tools like TradeGecko, Cin7, or inFlow Inventory can help you track what materials or products you have on hand, what’s been sold, and what needs to be restocked. 

This ensures that your COGS reflects real-time inventory changes and avoids mistakes.

Project management tools

For service-based startups, using tools like Asana, Trello, or Monday.com can help track project-based expenses. 

You can assign costs to specific tasks or projects, making it easier to calculate COGS for individual services. 

This level of detail helps you understand where your resources are going and how to price your services more effectively.

10. How COGS Affects Startup Valuation

Investor perspective on COGS

Investors love data, and COGS is a key figure they’ll look at when evaluating your startup. Why? Because COGS directly impacts your gross profit margin, which shows how efficiently you’re turning costs into revenue. 

The lower your COGS relative to your sales, the more profitable your business appears, and the more attractive it becomes to investors.

COGS and scalability

When investors look at your COGS, they’re not just thinking about current profitability; they’re also considering scalability. If your COGS is too high, scaling might mean spending more on production without enough return. 

On the other hand, if you can lower COGS as you grow, it means higher margins and greater long-term potential. Efficient scaling often comes down to optimizing COGS.

Gross margin benchmarks

Different industries have different gross margin expectations, and your COGS plays a big role in where you stand. 

For example, a tech startup might have a higher gross margin compared to a retail startup because their COGS (which might include server costs and software development) is lower relative to their revenue. 

Knowing the benchmarks for your industry can help you position your startup better in investor discussions.

11. Reducing COGS Without Sacrificing Quality

Sourcing cheaper materials

One of the easiest ways to lower COGS is by finding less expensive materials. However, cheaper doesn’t have to mean lower quality. Look for alternative suppliers or negotiate better deals with your current ones. 

If you’re a product-based startup, consider bulk purchases or exploring new suppliers for discounts.

Just make sure any cost-cutting measures don’t negatively affect your product’s quality, as this can hurt your brand in the long run.

Using technology to cut costs

Technology can be a game-changer in reducing COGS. For example, using automation tools in production can lower labor costs, and digital solutions like inventory management software can reduce waste. 

For service-based startups, tools that streamline your workflow (such as project management software) can save time and money by reducing manual processes.

Minimizing waste

For both product and service startups, waste is a hidden cost that can inflate your COGS. Reducing waste, whether it's excess materials or inefficient time spent on projects, is an effective way to lower COGS. 

Implementing lean manufacturing processes, just-in-time inventory, or project management systems can all help reduce unnecessary costs without impacting quality.

12. How to Present COGS in Financial Statements

Income statement breakdown

COGS shows up at the top of your income statement, right after revenue. This placement is important because it helps you calculate your gross profit (Revenue - COGS = Gross Profit). 

Keeping this figure accurate is essential for understanding your financial health, so don’t overlook COGS when preparing financial statements.

COGS for investors and banks

When pitching to investors or applying for loans, your COGS is a key metric that tells financial institutions how well you manage costs. 

Investors and lenders use this figure to determine whether your business is profitable and scalable. 

If your COGS is high, it may suggest that your margins are too slim, but if it’s well managed, it shows that you have control over your production or service costs.

Communicating COGS to your team

Finally, make sure your team understands why COGS matters. Everyone in your startup—especially those working in production or service delivery—should know how their work impacts costs. 

When your team is aware of COGS, they’re more likely to look for ways to reduce waste or increase efficiency, which directly benefits your margins and overall profitability.

Conclusion

Mastering your startup’s COGS isn’t just about getting your financials right—it’s about gaining control over one of the most critical levers for profitability. By understanding and optimizing your COGS, you can set better prices, make informed decisions on scaling, and present a solid case to investors. 

A leaner, more efficient COGS structure means stronger margins and a healthier business overall. Whether it’s through better supplier negotiations, reducing waste, or leveraging the right technology, staying on top of your COGS will put your startup on the path to sustainable growth. 

Now that you know the ins and outs of COGS, you’re better equipped to make smarter financial decisions and lead your startup to success.