Key Insight
What goes in COGS vs. operating expenses is one of the most inconsistent elements of small business accounting. Sellers who move expenses between categories year-to-year are making valuation analysis harder — sometimes intentionally.
What Belongs in COGS
COGS includes the costs that vary directly with revenue — the expenses incurred to deliver each unit of product or service:
Product businesses: Raw materials, purchased components, direct manufacturing labor, manufacturing overhead (depreciation on production equipment, production facility utilities)
Service businesses: Direct labor (technician wages, subcontractor payments), materials used in service delivery, direct overhead (vehicles used exclusively for service delivery)
Retail: Purchase cost of inventory sold
What Doesn't Belong in COGS
Fixed overhead and administrative costs are operating expenses, not COGS:
- Management and administrative salaries
- Marketing and sales expenses
- Rent and utilities (unless directly tied to production)
- Insurance, legal, accounting
- Owner compensation
COGS Misclassification
Two common patterns in small business accounting:
Inflated COGS: Moving operating expenses into COGS to artificially lower reported gross profit — reducing taxable income. This makes gross margins look lower than reality.
Deflated COGS: Capitalizing costs that should be expensed (treating purchases as inventory rather than expenses) to delay expense recognition — making near-term earnings look better.
Normalizing COGS to consistent accounting standards is part of the financial due diligence process.
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