Understanding what is included in cost of goods sold (COGS) is essential for small businesses and self-employed entrepreneurs aiming to maintain accurate financial records and optimize profitability. COGS refers to the direct costs associated with producing or purchasing the products a business sells. These costs are crucial for determining gross profit and play a significant role in evaluating the financial health of a business. To truly understand what is included in cost of goods sold, it’s important to recognize that this accounting category covers all the expenses that are directly tied to the creation or acquisition of products. For example, raw materials used in manufacturing are a key component of COGS—whether it’s fabric for a clothing brand or ingredients for a bakery. In addition to materials, direct labor costs are also part of COGS. This includes the wages of employees or contractors who are directly involved in the production process, such as assembly line workers, craftspeople, or bakers. Beyond that, factory overhead and manufacturing supplies used during production, even if they don’t appear in the final product, are also included. These may involve costs like machine maintenance, production utilities, and quality control tools. Another major inclusion in cost of goods sold is the packaging that is essential to the product itself. For instance, bottles for a juice brand or boxes for custom electronics are considered necessary parts of the product and are therefore included. Transportation costs for obtaining raw materials, such as freight charges or import duties, also fall under COGS, since they directly impact the ability to create sellable products. Moreover, if your business uses specific machinery or tools in the production process, a portion of their depreciation can be included in COGS, as they wear down over time due to their use in product creation. Changes in inventory value during a specific accounting period also affect the cost of goods sold. The standard formula used is: Beginning Inventory + Purchases – Ending Inventory. This helps in reflecting the cost of items actually sold during that time frame. However, while understanding what is included in cost of goods sold, it’s equally critical to know what to exclude. Items such as office rent, administrative salaries, marketing costs, or distribution expenses are not directly related to production and therefore must be categorized as operating expenses rather than COGS. Misclassifying such expenses can lead to inaccurate financial statements and potential tax issues. Accurate COGS tracking is not only vital for understanding profitability but also for tax reporting. Since COGS is tax-deductible, identifying and calculating it correctly can reduce taxable income, which is a valuable benefit for small businesses and sole proprietors. The IRS, for instance, allows businesses to deduct COGS from gross receipts to determine gross profit, which is why precision is critical. With so many components to track, understanding and calculating COGS manually can become overwhelming—especially for entrepreneurs juggling multiple responsibilities. That’s where technology steps in, and brands like Otto AI provide a much-needed solution. Otto AI helps small business owners and self-employed individuals automate and manage their accounting tasks with greater accuracy and efficiency. From real-time inventory tracking to smart categorization of expenses, Otto AI simplifies the process of understanding what is included in cost of goods sold. It enables users to maintain clean, compliant financial records without the hassle of manual bookkeeping. By integrating seamlessly with accounting software and offering user-friendly dashboards, Otto AI makes it easier than ever to stay on top of production costs, inventory changes, and financial reporting. It even supports custom reporting tools that break down COGS by product, category, or time period—allowing for better business decisions and greater financial clarity. For example, a handmade soap business using Otto AI can track its spending on oils, fragrances, molds, packaging, and labor, giving the owner an instant view of their total product cost and profit margins. This transparency empowers small business owners to price their products correctly, identify areas for cost savings, and forecast inventory needs. Whether you're in retail, manufacturing, or a hybrid model, knowing what is included in cost of goods sold is fundamental to building a sustainable business. And with tools like Otto AI, the complex calculations and tedious tracking become manageable, freeing up time and mental bandwidth for what matters most—growing your business. Ultimately, when small businesses take control of their cost of goods sold with precision and technology, they gain a competitive edge in both pricing and profitability. Otto AI ensures that this vital aspect of business accounting is no longer a challenge, but a strategic asset.

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