COGS vs. operating expenses: Definitions, differences, and examples

Cost of goods sold (COGS) and operating expenses (OpEx) are two essential components of your financial statement. COGS represents the direct costs of producing the goods or services your business sells, while OpEx covers the administrative and overhead costs of maintaining your daily operations.

Both COGS and operating expenses play a key role in determining your business's profitability. As the President of Brady CFO, a fractional CFO service firm, I’ve worked with many companies to help them manage these costs more effectively and optimize their financial performance.

Understanding these costs allows you to accurately analyze your business's financial health. By tracking and analyzing COGS vs. operating expenses, you can identify opportunities to improve your profit margins and price your products or services appropriately.

We cover the definitions of COGS vs. OpEx, explain their key differences, share real-world examples, and explain why distinguishing between the two is important for accurate financial reporting—and your bottom line.

What is cost of goods sold (COGS)?

Cost of goods sold, also called cost of sales, refers to the direct expenses of producing the goods or services your business sells. These are expenses that increase proportionally as you sell more.

COGS typically includes:

• Raw materials used to manufacture a product
• Direct labor costs for employees involved in the production of goods or services
• Manufacturing costs directly tied to production, such as factory utilities or equipment maintenance

COGS primarily applies to businesses that sell physical products or deliver services where costs scale directly with sales. For example, a furniture manufacturer would include wood and assembly labor in COGS, while a consulting firm might include consultants’ billable salaries as COGS.

COGS is reported on your income statement, directly subtracted from revenue to calculate your gross profit. This shows how much profit you make from sales after covering production costs.

What are operating expenses (OpEX)?

Operating expenses, also called operating costs, are the ongoing costs of running your business that aren’t directly tied to producing goods or services. These are often called overhead or administrative costs and generally stay steady regardless of sales volume.

Common examples of OpEx include:

• Rent for office or retail space
• Utilities
• Office supplies
• Administrative employee salaries
• Marketing and advertising
• Insurance and legal fees

OpEx covers the costs of running your day-to-day operations, outside of production. Unlike COGS, operating expenses are not factored into gross profit but are subtracted afterward to calculate net profit on your income statement.

COGS vs. OpEx: Key differences

Here’s a side-by-side look at how COGS and OpEx differ:

A common area of confusion is how to classify certain costs, such as labor or shipping. For example, a factory worker’s wages count as COGS, while an HR manager’s salary is OpEx. Similarly, shipping goods to customers after the sale is usually an operating expense, while shipping materials to the factory is part of COGS.

Examples of COGS in business operations

Cost of goods sold is easiest to analyze if you sell a physical product, but even service providers can track direct costs under a cost of services model. In all cases, COGS represents the direct costs that rise in proportion to sales.

COGS in manufacturing

Suppose your company manufactures furniture. The total cost of raw materials, such as nails and wood used to assemble the furniture, makes up COGS once that piece of furniture is sold.

It’s important to note that manufacturing costs are initially recorded in inventory. When the product is sold, the inventoried costs are relieved from inventory and recorded as COGS on your income statement. This ensures only the costs of goods actually sold during the period are recognized.

The COGS formula in manufacturing is typically:

Beginning inventory + Purchases/production – Ending inventory = COGS

The goal is to see whether your gross profit per unit sold is enough to cover fixed and operating expenses such as administrative salaries and insurance. If your margins are too low, you may need to adjust your pricing or production costs.

COGS in retail

For retail businesses, COGS reflects the wholesale cost of the products you purchase for resale.

A clothing store’s COGS would include the price paid to suppliers for inventory, such as shirts, pants, and accessories, that are later sold to customers. Just like in manufacturing, accurate inventory tracking is key to making sure only the cost of sold items is counted in COGS, not unsold inventory.

COGS in services

Even service businesses can track COGS, often called cost of services. In a consulting firm, for example, COGS includes the salaries, benefits, and pay of consultants who directly deliver the service. These costs increase as you take on more projects, since you may need to allocate more consultant hours, pay overtime, or even hire additional staff.

We worked with a service company whose accounting team incorrectly categorized vacation and sick pay for consultants as operating expenses instead of COGS. This caused their gross profit margin to appear higher than they actually were, leading to underpricing their services by about 1%–2% of sales. Once corrected, they were able to adjust their pricing and improve profitability.

Examples of OpEx in business operations

Operating expenses are the overhead costs your business incurs that can't be tied directly to a particular sale. These business expenses are often referred to as selling, general, and administrative expenses (SG&A) and typically include salaries and costs related to staff who aren’t directly involved in producing goods or delivering services.

For example, hiring an accountant doesn't produce a direct increase in sales. Over time, having an accountant might free up your time to focus on growing the business, but their pay and benefits can’t be directly linked to any specific product or service sold.

In general, OpEx in business are fixed expenses. For instance, your total cost of accounting salaries likely won’t increase just because sales rise by 10%. Instead, these costs tend to change at certain strategic increments rather than scale directly with production.

Fixed OpEx vs. variable OpEx

Some operating expenses can vary over time. Fixed OpEx are costs that remain steady regardless of sales, such as office rent or salaried administrative employees. Variable OpEx include expenses that can rise and fall with business activity, like utilities or office supplies.

Knowing which expenses fall under fixed vs. variable OpEx makes it easier to forecast cash flow and adapt to business growth or any slowdowns.

What percentage of sales should my COGS and OpEx be?

To start, it’s helpful to look into industry averages to get a baseline understanding of what’s typical in your field. Tools such as Vertical IQ are a great resource for finding industry fundamentals and financial benchmark ratios for various industries.

The ideal ratio also depends on your overall business strategy. For example:

• Discount retailer: Let’s say your COGS is high in comparison to your sales because you discount your prices. However, your OpEx is low because you spend very little on marketing and sales. The low-price nature of your products attracts a lot of customers, and you produce a strong net income. In this case, you're fine.
• Luxury retailer: In this case, let’s say you have a much lower COGS in comparison to sales because of your luxury pricing. However, your OpEx is substantially higher because you have to spend more on marketing to advertise your products to the right market. Even with this strategy, you may be able to produce a great net income.

As these examples show, different business models demand different COGS and OpEx ratios in proportion to sales, but both could still earn sufficient profits.

Why COGS and OpEx matter for your business

Properly classifying your costs as either COGS or operating expenses is more than just good accounting. It directly impacts your profitability analysis, pricing strategy, tax reporting, and overall decision-making for your business.

Accurately classifying your costs helps you clearly see your gross profit versus net profit, so you can understand how efficiently you’re producing goods or delivering services and with how much overhead. This insight helps you set prices, control costs, and ensure your profit margins are where they need to be.

It also ensures you stay compliant with tax laws. Misclassifying expenses can lead to errors in your tax filings and underreported or overreported income, which can lead to potential tax penalties or audits. Alternatively, it could make your margins appear healthier than they really are, which may lead you to underprice your offerings or miss opportunities to cut overhead.

How to use COGS and OpEx strategically to improve your bottom line

Running a business with high COGS and OpEx relative to sales can put your enterprise at a significant disadvantage, especially when compared to industry peers.

High COGS indicates that you're spending a lot to produce your goods or services. If these costs are excessively high compared to the income you're generating from sales, it could mean your pricing strategy needs adjustment, or you need to find ways to reduce production costs.

Similarly, high OpEx indicates substantial costs in maintaining your business operations. If these costs are too high, it might imply inefficiencies in how your business is run.

When both COGS and OpEx are high relative to sales, it squeezes your profit margins, making it challenging to generate a healthy net income. This situation becomes even more critical if your competitors are managing their COGS and OpEx more efficiently and enjoy better profitability.

It's important to continuously monitor metrics and optimize your COGS and OpEx. Proper management of these costs is a fundamental stepping stone on the path to success, as it paves the way for overall profitability and shields your business from potential economic pitfalls.

Manage your COGS and OpEx with Ramp

Effectively managing your COGS and operating expenses is key to running a profitable business, but tracking and controlling those costs manually can be both time consuming and leave room for errors.

Ramp’s expense management software gives you the tools to stay on top of your spending with ease. We offer built-in policies and controls so you can prevent unapproved or out-of-policy expenses before they happen, as well as real-time visibility into your direct and overhead costs.

Our automated workflows streamline approvals, match receipts, and ensure bookkeeping is accurate and up to date. Try an interactive demo to see why companies that choose Ramp save an average of 5% a year across all spending.