COGS vs Expenses: Know the Difference

Understanding the difference between Cost of Goods Sold (COGS) and operating expenses is critical for any business that wants to price products accurately, manage profitability, and grow sustainably. Yet many entrepreneurs blur the line between the two—often unintentionally—leading to distorted gross margins and confusing financials that can undermine both strategic decisions and tax outcomes.

Let’s break down these two categories, illustrate how they show up in different industries, and highlight what can go wrong if you don’t separate them properly.

What Is COGS?

Cost of Goods Sold, or COGS, includes all the direct costs required to produce a product or deliver a service. These are costs that rise or fall depending on how much you sell. If you didn’t make or sell the product, you wouldn’t incur these costs.

For example, in a manufacturing business, COGS includes the raw materials used to make each unit, the wages paid to workers directly assembling the product, and the supplies consumed in the production process. For a retail business, it includes the wholesale cost of inventory and the cost of getting that inventory shipped to your store. In a service-based business, such as a marketing agency, COGS might include freelancer or contractor payments that are directly tied to client work.

If your bakery stops making bread, you no longer need flour, yeast, or packaging materials. Those costs disappear, which makes them classic COGS.

What Are Operating Expenses?

Operating expenses are the costs of running your business that are not directly tied to production or sales volume. These costs continue even if you don’t sell anything this month. Think of them as the infrastructure that supports your business: rent, internet, employee salaries (if they’re not producing the goods), software subscriptions, advertising, insurance, and office supplies.

Let’s say you’re running an online store. The cost of your Shopify subscription, the salary of your marketing manager, and the money you spend on Facebook ads all count as operating expenses. They’re necessary for the business to function, but they don’t scale up and down based on how many units you sell.

Why It Matters

The distinction between COGS and operating expenses impacts two critical financial metrics: gross profit and net profit.

Gross profit is calculated by subtracting COGS from your revenue. This tells you how efficient your product or service is before factoring in overhead. Net profit, on the other hand, subtracts both COGS and operating expenses. Mixing the two categories gives you misleading results—potentially hiding whether your pricing is too low or your overhead is too high.

For example, if you accidentally classify rent or marketing costs as COGS, your gross profit will appear artificially low. If you classify direct labor or production materials as operating expenses, it may look like your business is extremely efficient—until cash flow problems reveal the truth.

Real-World Examples

Restaurants often see about 30% to 40% of their revenue consumed by COGS. This includes food, ingredients, and kitchen staff wages. A spike in food prices or labor costs directly affects COGS and shrinks gross profit. Front-of-house wages, rent, and marketing remain operating expenses.

SaaS companies, by contrast, often enjoy high gross margins of 75% to 80%, because their COGS are relatively low. These might include server costs, third-party API fees, and payment processor charges that scale with customer growth. However, engineering salaries, marketing teams, and office expenses are OpEx.

Retail stores have COGS that typically hover around 65% to 70% of revenue. This includes the wholesale cost of goods, shipping from the supplier to the store, and packaging. Operating expenses include things like utilities, staff salaries, and promotional spending.

Bakeries, which operate on thin margins, usually experience COGS around 30% to 37% of revenue. These are made up of ingredients like flour, eggs, and butter, along with the wages of bakers. Rent, utilities, and customer service wages belong to operating expenses. A 5% swing in egg prices—if not quickly adjusted for in menu pricing—can completely erase the month’s profit.

Consulting or service firms can also track COGS through "cost of services." If you're a freelancer who hires subcontractors to help deliver client projects, their fees should be recorded as COGS. This gives you visibility into project-level profitability, rather than burying those costs in general expenses.

Common Misclassifications

Some areas of business spending can feel like gray zones. For example, the cost of shipping goods from a supplier to your warehouse is COGS, because it’s part of getting your inventory ready for sale. But shipping finished goods to customers is an operating expense, since it happens after the sale. A software license that’s embedded in every unit of a smart device would be COGS, but your business’s general accounting software is not.

Another common mistake: misclassifying contractor labor. If a freelancer is helping with a one-time website update, it’s OpEx. But if you’re hiring a specialist to complete part of a project for a paying client, that cost should be treated as COGS.

Industry Benchmarks

It helps to compare your COGS and operating expense ratios to others in your industry. Here are some average gross margin figures to guide you:

• The average gross margin across U.S. industries is about 36.6%.

• Retail businesses often run on net margins as slim as 2% to 4%, so cleanly separating COGS from OpEx can be the difference between survival and failure.

• Restaurants typically aim to keep total “prime costs” (COGS plus labor) under 65% of revenue.

• SaaS companies with gross margins below 70% are considered inefficient by investors.

Misclassifying even small costs can make it hard to hit those benchmarks—or worse, lead you to believe you're hitting them when you’re not.

Best Practices

To keep your financial reporting accurate and useful, start by creating clear account categories in your accounting software for direct costs and operating expenses. Tag payroll items correctly—especially if some staff perform direct labor and others work in administration. Review your classifications at least quarterly, especially if you add new products, vendors, or services.

Regular inventory reconciliation is also key. If inventory shrinkage isn’t accounted for, your COGS will be understated and your margins will appear better than they really are. Similarly, if you change pricing or vendor terms, make sure your accounting reflects those updates.

The Bottom Line

Understanding the difference between COGS and expenses isn’t just an academic exercise—it’s a strategic tool. Getting it right helps you price products more accurately, improve profit margins, and make smarter hiring or investment decisions. It also builds credibility with banks, investors, and tax authorities.

If you’re a small business owner juggling everything from sales to spreadsheets, this one distinction can bring clarity to your financials—and confidence to your next big decision.