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What Is Cost of Goods Sold?
Cost of Goods Sold (COGS) is the direct cost of producing or buying the goods you actually sold in a given period. It links your inventory system to your income statement and tells you whether those sales are truly profitable.
COGS includes raw materials, direct labour, freight-in, and factory overhead (if you use absorption costing). It doesn’t include marketing, office rent, or owner salaries—those live below gross profit
Are you confident your business tax filings are fully optimized and compliant?
Why COGS Matters for Canadian Businesses
- Gross profit & margins: Revenue minus COGS equals gross profit. Miss the COGS math and your margin targets crumble.
- Tax savings: Under Canadian tax rules, a larger COGS means lower net income and—yes—lower income tax payable.
- Cash-flow health: Accurate COGS helps you right-size inventory buys and free up working capital.
- Lender confidence: Banks gauge risk by comparing your COGS and gross margins to industry norms published by StatsCan.
The Cost of Goods Sold Formula—Step by Step
| Step | Action | Example |
| 1 | Opening inventory – find your ending inventory from last period. | $40,000 |
| 2 | Add purchases – materials, finished goods, freight-in, duties. | + $120,000 |
| 3 | Equals goods available | = $160,000 |
| 4 | Subtract closing inventory – physical count or POS/ERP record. | – $35,000 |
| 5 | COGS | = $125,000 |
COGS formula:
COGS = Opening Inventory + Purchases – Closing Inventory
What Goes Into COGS—and What Stays Out
| Include (Direct Costs) | Exclude (Operating Costs) |
| Raw materials, parts, packaging | Advertising & sales commissions |
| Direct labour on the production line | Office rent & admin wages |
| Freight-in, customs, brokerage | Owner’s salary/dividends |
| Manufacturing utilities & shop supplies | Delivery to customers (freight-out) |
| Factory depreciation (if absorbed) | R&D and product design |
Choosing an Inventory Method in Canada
FIFO (First-In, First-Out)
Older costs flow to COGS first.
- Pros: aligns with physical flow, higher gross profit during inflation.
- Cons: bigger tax bill when prices are rising.
Weighted Average Cost
All unit costs blended into one average.
- Pros: smooths price swings, simple in cloud software.
- Cons: may hide rising input costs.
Tip: Canada does not allow LIFO for tax, so most SMEs pick FIFO or average cost.
Five Common COGS Mistakes
- Skipping physical counts– inventory shrink inflates gross profit and skews tax.
- Misclassifying freight-out– adding customer shipping raises COGS falsely.
- Including owner draws– personal pay is not a direct production cost.
- Using sales price for closing stock– inventory must be at cost, not retail.
- Mixing inventory methods– switching from FIFO to average mid-year confuses CRA and investors.
Real-Life COGS Examples
Retail (Boutique Apparel)
Opening inventory $60 k; Purchases $140 k; Closing $55 k → COGS $145 k. With revenue of $300 k, gross margin is 51.7 %. A sudden fall below 45 % could mean supplier price hikes or markdown pressure.
Manufacturing (Artisan Furniture Shop)
Direct lumber + hardware $90 k, shop wages $70 k, factory rent $20 k = COGS $180 k. Revenue $350 k → margin 48.6 %. Lower than sector peers? Revisit labour efficiency or negotiate lumber rates.
Food Service (Café)
Beginning food inventory $8 k; Food purchases $26 k; Ending $6 k → COGS $28 k. Revenue $75 k → food cost ratio 37.3 %. Benchmark QSR averages ~30-35 %; tighten waste control.
How to Lower Your COGS (Without Cutting Quality)
Bulk-buy with neighbours – combine orders to hit supplier volume discounts.
Negotiate freight contracts – compare LTL carriers or switch to rail for heavy imports.
Outsource sub-assemblies – sometimes a specialty shop builds parts cheaper than in-house.
Review scrap & waste reports weekly – small leaks compound fast.
Adopt perpetual inventory software – real-time alerts stop over-ordering.
COGS on Your Income Statement and Tax Return
- On the income statement, COGS sits immediately under “Sales” and above “Gross Profit.”
- On Schedule 125 (T2) or Form T2125 for sole proprietors, COGS lines include opening inventory, purchases, direct wages, and closing inventory.
- CRA compliance – maintain invoices, count sheets, and costing reports for six years in case of audit.
Frequently Asked Questions
What’s the quickest way to calculate cost of goods sold?
Use the simple formula: opening inventory + purchases – closing inventory. Our free COGS calculator automates it.
Does COGS affect cash flow?
Yes. High COGS often means heavy inventory buys that drain cash. Tracking it monthly helps you order smarter.
Can service businesses have COGS?
Pure service firms list “cost of services”—mainly direct labour. The concept is similar even though there’s no physical stock.
How often should I update COGS?
At least each reporting period (monthly or quarterly). Fast-moving retailers may track it weekly.
What happens if I overstate closing inventory?
COGS becomes artificially low, inflating profit and tax. CRA penalties may follow if discovered.
Key References
- Government of Canada – Business income tax: inventory valuation
- BDC – Gross profit margin ratio guide
- Investopedia – Cost of Goods Sold (COGS) Definition
- Xero – “What is gross profit margin?”
