Your profit margins look reasonable on paper. You're pricing competitively. You feel like you have a handle on costs. Then your accountant delivers year-end numbers and you're staring at a bottom line that doesn't come close to what you expected. Sound familiar?
There's a silent financial villain behind this disconnect, and it has nothing to do with slow sales or bad luck. It has everything to do with your COGS—specifically, whether what you're calling "Cost of Goods Sold" is actually that, or whether it's really an ECOGS: an Estimated Cost of Goods Sold that masquerades as fact while quietly destroying your margins, corrupting your pricing decisions, and feeding you financial data you can't trust.
This article is about the gap between what you think your COGS is and what it actually is—and why closing that gap may be the single most profitable thing you do this year.
What COGS Actually Is (and What Too Many Business Owners Think It Is)
Cost of Goods Sold is the total of all direct costs required to produce or deliver whatever you sell—nothing more, nothing less. For a product-based business, that includes raw materials, direct labor tied to production, packaging, and freight to acquire inventory. For a service business, it includes the direct labor and materials tied specifically to delivering that service.
What COGS is not: rent, marketing, administrative salaries, your office supplies, or the general overhead that keeps your business running regardless of how much you sell. Those belong in your operating expenses, and mixing them with COGS is one of the most common and damaging errors in small business accounting.
The problem is that most small business owners learned their COGS number from a single moment in time—when they first opened, when they set their original pricing, or when a bookkeeper ran the calculation a couple of years ago. They've been using it ever since. Supplier costs have risen. Labor rates have changed. New processes have been added. Waste percentages have shifted. But the COGS number in their head—the one they're pricing against and planning around—hasn't moved.
That's ECOGS. Estimated. Outdated. Unreliable. And making every financial decision you think is smart actually quite dangerous.
Why ECOGS Is So Destructive to Decision-Making
When your COGS is wrong—even slightly—every financial calculation downstream becomes corrupted. Consider the chain reaction:
Pricing becomes guesswork
You set prices based on the margin you think you're achieving. If your real COGS is 15% higher than your assumed COGS, your "20% profit margin" is actually 5%, and one cost spike turns it negative. You're selling yourself into a hole with every transaction, convinced you're profitable because the math works—it just works with the wrong numbers.
Gross profit is a fiction
Gross profit is simply revenue minus COGS. If your COGS is inflated or understated, your gross profit figure is meaningless. Business owners make expansion decisions, hiring decisions, and investment decisions based on gross profit. Build those decisions on false data and you're scaling a broken foundation.
Operating decisions get distorted
Should you take that large contract? Is this product line worth keeping? Should you raise prices or cut costs? All of these questions require knowing your actual unit economics. ECOGS makes the answers unreliable, often leading to doubling down on unprofitable lines and abandoning profitable ones because the numbers say the opposite.
Your financial statements are misleading
If you ever seek financing, attract investors, or consider selling, your P&L becomes scrutinized. Embedded ECOGS errors can mean the difference between a business that appears healthy and one that reveals serious structural problems under due diligence—often at the worst possible moment.
The Top 4 COGS Myths and Mistakes Small Business Owners Make
"My Bookkeeper Handles COGS—It's Accurate"
My bookkeeper calculates COGS, so it must be accurate and I don't need to verify it.
Bookkeepers classify and record what you provide. They don't audit whether you've captured every cost component.
This is perhaps the most dangerous assumption in small business finance. Your bookkeeper records what you tell them, categorizes what you show them, and works with the data you provide. If you're not tracking every direct cost component in real time and passing it to your accounting system accurately, your bookkeeper is calculating COGS based on incomplete information—and producing clean, official-looking financial statements built on a shaky foundation.
Bookkeepers classify and record. They are not typically auditing whether you've captured every cost component at the product or service level. The responsibility for COGS accuracy begins with the business owner who understands the true cost structure of their operations.
The fix: Walk your COGS calculation from the bottom up at least twice a year—not just the formula, but every line item that feeds it. Reconcile to actual supplier invoices, actual labor records, actual waste logs. Then give that ground-level data to your bookkeeper.
"COGS Is Just Materials and Direct Labor—I've Got That Covered"
COGS = raw materials + direct labor. That's it. I've got those numbers.
Freight, packaging, spoilage, labor burden, and rework are all direct costs that routinely fall through the cracks.
Technically correct definition, catastrophically incomplete application. Most small business owners know the textbook components of COGS but systematically miss the line items that make it accurate in practice.
What routinely falls through the cracks:
- Inbound freight and shipping to receive your materials or inventory. If you paid $800 to receive a shipment, that's a COGS component—not an operating expense.
- Packaging materials directly tied to your product. Every box, bag, label, and wrap consumed per unit sold belongs in COGS.
- Spoilage, waste, and shrinkage. If 8% of your perishable inventory spoils before sale, that 8% is a direct cost of doing business that belongs in your COGS calculation, not your "miscellaneous" expense category.
- Direct labor burden. Not just wages, but the true cost of the labor that produces your product or delivers your service—including payroll taxes, workers' comp, and benefits allocated to production hours. Many businesses use base wages and ignore the fully-loaded labor cost, understating COGS by 25-40%.
- Quality control and rework. If a significant portion of production hours go toward fixing errors before items go to customers, those hours are a direct cost of getting your product out the door—and they belong in COGS.
The fix: Build a COGS component checklist specific to your business and run it quarterly. Every category of direct cost—not just the obvious two—deserves a line in your calculation.
"Prices Haven't Changed Much—My COGS Is Still Close Enough"
Costs haven't changed much, so my COGS from a few years ago is still close enough.
A 3-year-old COGS figure may be 15-30% off from reality due to inflation, labor, and freight changes.
"Close enough" is the phrase that quietly bankrupted more small businesses than any recession. COGS is not static. It breathes with supplier pricing, labor rates, shipping costs, waste percentages, and production efficiency—all of which are constantly in motion.
A business that accurately calculated COGS three years ago and hasn't updated it since is operating with a number that may be 15-30% off from reality, depending on their industry and the cost pressures of the past few years. Inflation hit supply chains hard. Labor markets tightened. Freight costs spiked. If you absorbed those increases without recalculating COGS, you absorbed them directly into your margin without realizing it.
The insidious part: revenue can hold steady or even grow while COGS quietly drifts higher, making your true margins erode invisibly. You feel like business is fine. Revenue is up. Customers are happy. Then you look at actual cash retained and wonder where it went.
The fix: Recalculate COGS from actuals every quarter, or at minimum every six months. Any time a major supplier raises prices, a labor cost changes, or a new process is added to production, trigger an immediate COGS update.
"My COGS Is Fine—My Pricing Is Profitable"
I'm still in business and generating revenue, so my pricing must be profitable.
Survival ≠profitability. Many businesses run at structural losses funded by working capital drawdowns.
This is the most self-reinforcing of the four myths because it feels validated by the fact that you're still in business and generating revenue. But profitability isn't confirmed by survival—it's confirmed by margin. And many businesses maintain positive cash flow for years while actually running at structural losses, funded by working capital drawdowns, owner salary suppression, or simply not accounting for the true cost of owner time.
The tell: you're busy, revenue is healthy, but cash never accumulates the way the numbers suggest it should. You're constantly reinvesting just to stay operational. Distributions are smaller than expected. There's never quite enough cushion. This is often ECOGS at work—you're pricing to cover what you think you cost, not what you actually cost.
Profitable pricing requires knowing your real COGS with precision, then applying a margin that covers operating expenses AND generates genuine net profit. The sequence matters: COGS first, margin target second, price last. Most small businesses do it backwards—price based on market, back into an assumed margin, and never truly validate the COGS underneath.
Industry-Specific Examples: What ECOGS Costs You in Practice
Restaurant and Food Service
A restaurant owner prices a signature dish based on food costs from when she designed the menu eighteen months ago. Since then, her protein supplier has raised prices twice, her waste percentage has increased as kitchen staff turnover brought in less experienced prep cooks, and she added packaging for takeout orders she didn't originally offer.
Assumed
28%
food cost
Actual
37%
food cost
Weekly Loss
$432
margin erosion
Annual
$22K+
phantom profit
From a single menu item sold 80Ă—/week at $24.
Residential Contracting (Plumbing, HVAC, Electrical)
A plumbing company calculates labor cost using base wages—$32/hour per technician. They build their estimates and pricing on this number, targeting a 35% gross margin. What they haven't factored in: payroll taxes, workers' comp, tool replacement, vehicle costs allocated per job, and the unbillable drive time absorbed into job costs.
Base Wage
$32/hr
what they use
Fully Loaded
$54/hr
true cost
Real Margin
14%
vs 35% assumed
Owner declines a price increase because "we're already competitive and profitable." Learn more about fully-loaded labor costs.
E-Commerce and Product Retail
An online retailer calculates COGS as product cost plus inbound shipping. They don't include outbound fulfillment labor, packaging materials, return processing costs, or the allocation for damaged/unsellable inventory sitting in their warehouse. Their COGS calculation covers perhaps 70% of their true direct costs.
Reported Margin
42%
looks healthy
Actual Margin
28%
reality
Scaling paid ads on a business with structural margin problems—buying more revenue at a loss.
Professional Services (Consulting, Marketing, Law, Accounting)
Service businesses often believe COGS doesn't apply to them in any meaningful way—they don't have inventory, so the concept feels irrelevant. This is a critical misunderstanding. For service businesses, COGS is primarily the direct labor cost of delivering the service, and it must include the true, fully-loaded cost of that labor—not just the billable hours at base wage.
Marketing Agency
A marketing agency uses contractor hours as their primary COGS input. But they're not capturing the senior account manager hours spent reviewing contractor work, the platform subscription costs directly tied to client deliverables, or the rework hours when campaigns require revision. Their "direct delivery cost" is understated by 30%.
Expected
50%
gross margin
Actual
35%
gross margin
Ghost $
$180K
per year
On $1.2M revenue—money mentally allocated to growth that isn't there.
Retail (Boutique, Specialty Products)
A boutique clothing owner treats COGS as wholesale cost only—what she paid per item. She doesn't include freight to her store, the proportion of her buying trip expenses allocable to inventory acquisition, the packaging she uses per sale, or the markdown value of seasonal items that sell below cost at end-of-season clearance.
Believed Margin
50%
keystone pricing
Actual Margin
38-42%
reality
Not enough to support expansion plans financed on projected margins that don't exist.
Getting to Actual COGS: Where to Start
The goal is precision over convenience. Here's a practical path:
Build a full direct cost inventory
List every single cost category involved in producing or delivering your product or service. Don't start with what you've been tracking—start with what exists. Walk through the physical process of producing one unit, job, or service and capture every resource consumed.
Source actuals, not assumptions
Pull real invoices, real time records, real waste logs. If you discover you've been estimating any component, that's your ECOGS risk zone. Replace estimates with actuals immediately.
Calculate fully-loaded labor
Don't use base wages. Include all employment costs allocated to production: payroll taxes, workers' comp, benefits, and any equipment or tools used exclusively for production. This single step often reveals the largest COGS understatement. Learn more in our guide to calculating fully burdened labor rates.
Build in indirect direct costs
Some costs are hard to attribute per unit but are genuinely variable with production—quality control time, rework hours, waste disposal, inbound freight. Develop reasonable allocation methods and include them.
Create a review cadence
COGS accuracy isn't a one-time project—it's an ongoing discipline. Build quarterly reconciliation into your financial rhythm. Any time a significant cost input changes, trigger an update.
The Pricing and Strategy Reset That Follows
Once you have real COGS, two things typically happen: you discover you've been underpricing, and you identify specific products or services where you've been losing money without knowing it. Neither discovery is comfortable. Both are transformative.
On Underpricing
The market may have absorbed more than you've asked for. Many small business owners fear price increases will drive customers away, but they've been leaving margin on the table—and providing more value per dollar than competitors—precisely because their ECOGS led them to underprice. Correcting COGS often enables confident price adjustments that customers accept because your value genuinely supports the new numbers.
On Unprofitable Lines
Every business has them—products or services that feel like revenue contributors but are actually margin destroyers once real COGS is applied. Identifying and rationalizing these lines is one of the highest-leverage financial moves available to a small business. Stopping losses is just as powerful as adding gains.
This is where a comprehensive business health assessment becomes valuable. Tools like BizHealth.ai identify financial gaps—including COGS accuracy and pricing health—alongside operational and strategic factors, giving you a complete picture of where your business is genuinely healthy and where the numbers you've been trusting may be leading you astray.
The Bottom Line on COGS
Every financial decision you make—pricing, hiring, expanding, investing, declining—flows from the numbers your business reports. If the foundational number of COGS is wrong, everything built on it is wrong. Not catastrophically, in ways you immediately notice, but quietly, structurally, in ways that accumulate into the gap between the business you expected to build and the one you actually have.
The difference between COGS and ECOGS isn't accounting precision for its own sake. It's the difference between decisions made with accurate intelligence and decisions made with comfortable illusions.
Your competitors who understand their true costs price with confidence, invest strategically, and scale sustainably. Your competitors operating on ECOGS are hoping the numbers work out—and discovering too late that hope isn't a financial strategy.
Know your real COGS. Build pricing and strategy on it. Review it relentlessly. The business that earns the margin you deserve starts with the number you actually are.
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BizHealth.ai Research Team
The BizHealth.ai Research Team combines decades of experience in small business operations, financial management, and strategic consulting. Our mission is to deliver actionable, data-driven insights that help small and mid-size business owners make smarter decisions, improve profitability, and build sustainable growth.