How to Analyze COGS for Better Profit Margins

Want to improve your profit margins? Start with your Cost of Goods Sold (COGS).

COGS represents the direct costs of producing goods, such as materials, labor, and factory overhead. Tracking and analyzing it can reveal inefficiencies that eat into your profits. Here's what you need to know:

• Why COGS matters: It directly impacts gross profit, helping you understand how efficiently your business operates.
• Key components: Direct materials, direct labor, and manufacturing overhead are the three main cost drivers.
• How to calculate it: Use the formula:
  COGS = Beginning Inventory + Purchases – Ending Inventory (or include Total Manufacturing Costs for manufacturers).
• Spot inefficiencies: Rising COGS-to-revenue ratios, waste, and inventory buildup signal problems.
• Actionable steps: Break down COGS by product, compare with industry benchmarks, and reduce costs via better supplier deals, labor management, and technology.

Small changes in COGS - like negotiating better material prices or cutting waste - can lead to significant profit gains. Let’s dive deeper into how to analyze and manage COGS effectively.

COGS Calculation: Finding the best path to profitability

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What COGS Is and Why It Matters

Cost of Goods Sold (COGS) refers to the direct costs involved in producing the goods your business sells. This includes expenses like raw materials and wages for production workers, but it excludes indirect costs such as marketing efforts, office rent, or administrative salaries.

Knowing what constitutes COGS is key to identifying inefficiencies and improving profit margins. A simple way to determine if an expense qualifies as COGS is to ask: Would this cost still exist if no sales were made? For instance, the steel used to build a car chassis is required before any sale happens, so it falls under COGS. On the other hand, sales commissions are only incurred after a sale and are classified as operating expenses.

COGS is vital because it directly impacts gross profit, which is calculated by subtracting COGS from revenue. Without accurate COGS tracking, businesses risk setting incorrect prices, mismanaging inventory, forecasting expenses poorly, and even miscalculating taxable income. As financial analyst Henry Sheykin points out:

If you don't nail this number, your gross profit - and every subsequent financial decision - is wrong ^[8].

The Three Main Components of COGS

COGS can be broken down into three primary categories:

• Direct Materials:
  These are the raw materials that become part of the finished product, such as steel, lumber, or electronic components. For example, U.S. manufacturers in 2025 expect direct materials to account for 35% to 45% of their total COGS ^[6].
• Direct Labor:
  This includes wages, payroll taxes, and benefits for workers who transform raw materials into finished goods. Due to labor shortages and rising wages, direct labor costs are projected to increase by 5.5% year-over-year in 2025 ^[6].
• Manufacturing Overhead:
  These are indirect production costs that can't be easily tied to a specific product, such as factory utilities, equipment depreciation, and supervisor salaries. For instance, a factory supervisor's salary is part of COGS, but a corporate sales manager's salary is not. Additionally, automation investments, like advanced assembly lines, often shift costs from direct labor to overhead ^[6].

Each component plays a critical role in determining gross margin, making it essential to track them accurately.

How COGS Affects Gross Profit Margins

COGS directly influences gross margins, which represent the profit left to cover other operating costs like rent, marketing, and administrative expenses. If COGS increases as a percentage of revenue, gross profit shrinks proportionally.

By analyzing COGS, you can measure efficiency using metrics like the Gross Margin Percentage (GMP). For example, if your gross margin is 30% but competitors achieve 35%, a closer look at your COGS might reveal issues like high material costs, inefficient labor practices, or poorly managed overhead. Misclassifying costs can distort gross margins and lead to flawed strategic decisions, especially as commodity prices remain volatile through late 2025 ^[8].

Understanding COGS is more than just number-crunching—it’s about making smarter decisions with the help of fractional CFO services. Next, we’ll dive into how to calculate COGS accurately, so you can put this knowledge into action.

How to Calculate COGS

The COGS Formula

The formula for calculating COGS (Cost of Goods Sold) is straightforward:

COGS = Beginning Inventory + Purchases – Ending Inventory

For manufacturers, the term "Purchases" is replaced by Total Manufacturing Costs, which includes direct materials, direct labor, and manufacturing overhead.

Here’s an example: Let’s say your factory begins January with $50,000 in inventory. Over the month, you spend $120,000 on manufacturing costs, covering raw steel, assembly worker wages, and factory utilities. By the end of the month, $40,000 worth of inventory remains unsold. Your COGS would be:

$50,000 + $120,000 - $40,000 = $130,000

Many manufacturers take a more detailed approach by first calculating the Cost of Goods Manufactured (COGM). They then apply this to the COGS formula:

COGS = Beginning Finished Goods Inventory + COGM - Ending Finished Goods Inventory

This method incorporates all inventory types - raw materials, work-in-progress, and finished goods - offering a clearer picture of production efficiency.

Tips for Accurate Calculations

Getting your COGS right is critical for managing costs effectively. Here are some tips to ensure accuracy:

• Leverage Automated Systems: Tools like QuickBooks, NetSuite, or Sage can sync real-time data, reducing manual errors. Perpetual inventory systems, which update continuously as materials move through production, provide immediate insights and eliminate the need for end-of-month reconciliations.
• Perform Regular Inventory Counts: Routine cycle counts, paired with an annual full audit, help align system records with physical stock. This is crucial because inventory shrinkage due to theft, damage, or errors costs U.S. businesses about 1.5% of total sales - projected to hit $115 billion across retail by 2025 ^[6]. Spotting discrepancies early can prevent financial misstatements.
• Exclude Non-Production Costs: Ensure only production-related expenses are included in COGS. Costs like marketing, administrative salaries, and distribution should be classified as operating expenses. As Nauman Poonja of Accounovation explains:

  If you don't know your true cost per unit, it's impossible to identify which products are profitable, which need reengineering, or how volume shifts affect margins.

• Account for Obsolete Inventory: Write down outdated or unsellable inventory to avoid overstating ending inventory. Inflated inventory values can understate your COGS and distort profitability.
• Update Labor Rates Regularly: Direct labor costs are on the rise, increasing by 5.5% year-over-year in 2025 ^[6]. Keeping your rates current ensures accurate cost allocation.
• Stick to a Consistent Overhead Allocation Method: Whether you allocate overhead based on machine hours or labor hours, consistency is key. Changing methods mid-year can obscure trends and make it harder to compare performance across periods.

Accurate COGS calculations not only clarify your financials but also set the stage for identifying inefficiencies in production.

How to Analyze COGS to Find Inefficiencies

Taking a closer look at your Cost of Goods Sold (COGS) is critical for spotting inefficiencies that can chip away at your profit margins. Once you've nailed down an accurate COGS calculation, the next step is to dig into the numbers and identify the specific cost drivers behind them. The goal? Address these issues before they spiral into larger problems. As Scott Beaver, Senior Product Marketing Manager at NetSuite, puts it:

Increasing COGS relative to revenue signifies potential cost drivers ^[2].

Start by tracking your COGS-to-revenue ratio every month. If this ratio is climbing, it could be a sign of rising input costs, operational waste, or quality control issues. Another red flag is excessive inventory growth. When inventory levels rise faster than sales, it often points to poor demand forecasting or outdated stock that may need to be written off ^[1][2]. For example, cutting inventory days from 60 to 45 on a $5 million inventory balance can free up about $833,000 in cash ^[9].

Keep an eye on material waste and scrap rates, too. Even a 5% waste rate can mean losses in the hundreds of thousands annually, depending on your production scale ^[9]. High rates of customer returns, frequent reworks, or excessive overtime and idle time are other indicators of inefficiencies in labor cost management ^[2][9]. Considering that U.S. labor inflation is averaging 3% to 4% annually as of 2025 ^[9], even small inefficiencies can add up quickly.

To dig deeper, break down your COGS by product line and benchmark your performance against industry standards to uncover more specific inefficiencies.

Analyzing COGS by Product Line

After identifying broad inefficiencies, breaking down COGS at the product level can help you zero in on specific opportunities for improvement. By calculating the COGS for each product or category separately and comparing their gross margins, you may discover that certain product lines consistently deliver lower margins. This could mean it's time to consider redesigning, repricing, or even discontinuing those products ^[2].

This detailed breakdown allows you to allocate resources more effectively. For instance, if one product line generates significantly higher revenue with better margins than another, it’s clear where your improvement efforts should focus. On top of that, with an annual material spend of $10 million, achieving just a 2% to 3% cost reduction through better supplier negotiations could save $200,000 to $300,000 ^[9]. Identifying which product lines consume the most materials can help prioritize these negotiations.

Comparing COGS to Industry Benchmarks

Internal analysis is helpful, but comparing your performance to industry benchmarks can provide even more clarity. If your gross margins consistently fall below industry averages, it might indicate inefficiencies in your production processes that are cutting into your profits ^[2].

Metrics like inventory turnover (COGS divided by average inventory) can help you assess how quickly you're moving stock. A low turnover rate compared to industry norms might suggest overstocking or slow-moving inventory driving up carrying costs ^[2]. Similarly, comparing labor costs per unit and waste rates to industry data can highlight other problem areas. To ensure fair comparisons, standardize your accounting practices using U.S. Generally Accepted Accounting Principles (GAAP) ^[2]. Keep in mind that COGS can sometimes be manipulated, such as through aggressive overhead allocation or failing to write off obsolete inventory, which can skew benchmarks ^[1].

Here’s a quick look at some key indicators and actions you can take:

Analyzing these metrics closely can help you identify and fix inefficiencies, keeping your operations lean and your margins healthy.

Strategies to Reduce COGS and Improve Margins

Addressing inefficiencies in your Cost of Goods Sold (COGS) can lead to significant profit improvements. For example, small gains - like cutting material costs by 5%, boosting labor efficiency by 8%, and trimming overhead by 10% - can collectively raise operating profits by 36% ^[7]. These incremental changes don’t require a massive overhaul but can still have a big impact.

Start by categorizing your production activities into three groups: value-added (what customers willingly pay for), non-value but necessary (like compliance checks), and pure waste (such as defects, rework, or unnecessary movement) ^[7]. As Nauman Poonja, Founder of Accounovation, puts it:

Cost structure analysis reveals where profit margin improvements hide and provides the roadmap to capture them strategically rather than desperately ^[7].

The first target should be pure waste - eliminate scrap, rework, and redundant processes for immediate gains. Then, streamline non-value tasks and enhance efficiency in value-added activities.

Another tactic is SKU rationalization, which involves reducing low-value product variations that complicate production and inflate inventory costs ^[7]. Additionally, shift from reactive repairs to preventive maintenance to minimize downtime and its associated expenses ^[7]. These operational tweaks, though small, can lead to lasting improvements in your margins. Below, we’ll explore specific strategies to enhance procurement, improve supply chain efficiency, and use technology for better cost management.

Improving Procurement and Supply Chain Efficiency

Procurement and supply chain operations are prime areas to cut costs and reduce COGS. Regularly renegotiate supplier contracts to secure benefits like volume discounts, extended payment terms, and price stability ^[2][4]. Another approach is input substitution - finding alternative materials that meet quality standards at a lower cost ^[2][4]. Assess whether your current materials are over-specified and consider "good enough" options that balance cost and quality ^[7].

Shipping and inventory management also offer savings opportunities. Consolidating shipments and negotiating discounts with carriers can reduce logistics expenses ^[5][4]. Implementing Just-in-Time (JIT) inventory principles and demand forecasting helps avoid overstocking, cutting storage costs and reducing the risk of obsolescence ^[2][4]. For perishable or time-sensitive items, a First-In, First-Out (FIFO) system ensures older stock is sold first, minimizing waste ^[5][2]. Strengthen quality control by conducting inspections at multiple stages of production to catch defects early, which reduces costs tied to scrap, rework, and returns ^[2].

Leveraging Technology for Real-Time Cost Insights

Technology plays a vital role in refining cost management. Modern ERP systems and perpetual inventory systems provide real-time updates on inventory and costs ^[3]. Unlike periodic systems that rely on scheduled counts, perpetual systems continuously update stock levels, offering more accurate data ^[3].

Advanced software can also calculate average landed cost, which factors in not just the purchase price but also hidden expenses like freight, insurance, and labor ^[4]. This detailed cost analysis helps you make smarter pricing and sourcing decisions. Regular physical inventory counts and audits ensure your system data aligns with actual stock, reducing errors, shrinkage, and fraud ^[3][2]. As Nauman Poonja advises:

Cost optimization isn't a one-time project. Embed continuous improvement in your culture ^[7].

How Phoenix Strategy Group Can Help with COGS Analysis

Getting a handle on COGS (Cost of Goods Sold) takes more than just standard bookkeeping. It requires advanced tools and real-time insights that many manufacturers might not have on hand. That’s where Phoenix Strategy Group steps in. They specialize in financial and strategic advisory services that identify hidden cost inefficiencies and help businesses improve their profitability. By focusing on unit economics, they use tools like the Unit Economics Profitability Converter and Financial Metrics Benchmark Analyzer to break down revenue, costs, and sales data into per-unit profitability. This approach uncovers inefficiencies that traditional methods tend to miss. On top of that, their data engineering capabilities create real-time dashboards for inventory and cash flow, integrating seamlessly with existing ERP systems. These dashboards help manufacturers avoid operational blind spots, like stockouts, and keep everything running smoothly ^[10].

But Phoenix Strategy Group doesn’t stop at analysis - they also help refine procurement and operations. For procurement, they use spend analytics and Total Cost of Ownership (TCO) benchmarks to negotiate better supplier deals and lower input costs. Their Fractional CFO services take things further with driver-based scenario planning, which separates fixed costs from variable ones to protect profit margins ^[10].

Automation is another key part of their process. By automating accounting tasks, they reduce manual bookkeeping by about 80%, speeding up month-end closings and cutting down errors. Their FP&A (Financial Planning and Analysis) teams also optimize spending with real-time data forecasting, reducing cloud-related waste by 15–20%. Meanwhile, their Budget Variance Estimator flags cost variances, allowing businesses to take corrective action quickly ^[10]. These tech-driven efficiencies set the stage for long-term success.

For manufacturers aiming to improve their margins, Phoenix Strategy Group also offers specialized programs like "Build a Self-Running Business" and "Execute Your Exit." These tracks go beyond COGS analysis, combining financial clarity with strategies for operational independence. Together, these tools and services make COGS analysis an ongoing, proactive strategy for boosting profitability ^[10].

Conclusion

COGS analysis plays a critical role in helping manufacturers safeguard and expand their profit margins. By breaking down and tracking costs, businesses can identify inefficiencies before they start chipping away at profits. As Nauman Poonja, Founder of Accounovation, emphasizes:

The key is making cost analysis ongoing discipline rather than crisis response ^[7].

The rewards of consistent COGS analysis are undeniable. Small changes - like reducing material costs by 5%, improving labor efficiency by 8%, and cutting overhead by 10% - can lead to a 36% increase in profits ^[7].

Establishing a regular review schedule is key. Monthly scorecards can uncover budget discrepancies early, quarterly reviews can highlight developing trends, and annual strategic evaluations ensure your cost structure aligns with long-term growth goals ^[7]. This structured approach helps avoid drastic, last-minute decisions like layoffs or service cuts. Instead, it supports a proactive, well-thought-out strategy that complements the detailed analysis methods outlined earlier.

Successful businesses weave continuous improvement into their operations. They use COGS analysis to guide critical decisions - like setting product prices, determining the right product mix, evaluating make-or-buy scenarios, and deciding on automation investments ^[2][3]. This discipline not only builds resilience against market fluctuations but also positions companies to grow profitably, even when facing challenges like rising material costs or fierce competition ^[7].

As Scott Beaver, Senior Product Marketing Manager at NetSuite, points out, understanding and managing COGS can be the difference between running a profitable business and struggling with inefficiency ^[2]. Regular COGS analysis provides the insights needed to unlock margin improvements and drive sustainable growth.

FAQs

What costs should I include in COGS vs operating expenses?

When calculating Cost of Goods Sold (COGS), focus on direct costs - these are the expenses directly tied to creating or purchasing the products you sell. They include:

• Raw materials: The essential components or ingredients used to manufacture your product.
• Direct labor: Wages paid to workers who are directly involved in production.
• Manufacturing supplies: Items consumed during the production process, like tools or packaging materials.

These costs are unique because they stop when production or purchasing halts.

On the other hand, operating expenses - like administrative salaries, marketing, rent, utilities, and other overhead costs - should not be part of your COGS. These are categorized separately, as they aren't directly tied to production or procurement.

By focusing only on direct costs, you'll get a clearer picture of your gross profit margins and a more accurate understanding of your business's profitability.

How do I calculate COGS if I’m a manufacturer with WIP inventory?

To calculate Cost of Goods Sold (COGS) as a manufacturer with Work in Progress (WIP) inventory, you’ll first need to determine the Cost of Goods Manufactured (COGM). Use this formula:

COGM = Beginning WIP Inventory + Total Manufacturing Costs – Ending WIP Inventory

Once you have the COGM, move on to calculate COGS. Here’s how:

• Start with the beginning finished goods inventory.
• Add the COGM.
• Subtract the ending finished goods inventory (if applicable).

This approach ensures you account for inventory changes and production costs, giving you the total cost of goods sold for the period.

Which COGS metrics should I track monthly to spot inefficiencies fast?

To stay on top of your Cost of Goods Sold (COGS), it’s important to track a few key metrics every month. Start with material costs, direct labor costs, and manufacturing overhead - these can reveal any price shifts, inefficiencies, or waste in your production process.

You’ll also want to keep an eye on inventory levels and turnover rates. This helps you avoid problems like overstocking, which ties up capital, or stockouts, which can disrupt sales. Lastly, analyzing cost drivers and variances can highlight areas where inefficiencies might be hiding.

By consistently monitoring these metrics, you can spot issues early and take steps to protect your profit margins.

Related Blog Posts

• Unit Economics: Fixing Inefficiencies To Boost Margins
• How to Spot and Fix Supply Chain Spend Leaks
• How CFOs Use Data for Real-Time Cost Optimization
• Lean CFO Role in Waste Reduction and Cost Control