Is Your Profit a Lie? Why Getting COGS Right Matters More Than You Think

Too many small and mid-sized business owners glance at their P&L, see a healthy profit, and assume all is well; until cash runs short, forecasts fail, or pricing decisions backfire.

One root cause? They’re misclassifying or altogether skipping Cost of Goods Sold (COGS). This quiet misstep turns your financials into fiction, and your decisions into guesswork.

If you don’t understand what belongs in COGS (and what doesn’t), your gross margin becomes meaningless. And without margin, you’re flying blind.

What is COGS – Really?

COGS represents the direct costs to produce and deliver your product or service. It’s the money you must spend only because you made the sale.

Not everything that costs money belongs here. Misclassify, and you inflate your gross margin. Miss items, and your true profitability vanishes into thin air.

The Real-World Impact of Misclassifying COGS

Let me give you two examples.

The Construction Firm With Phantom Profits
They looked wildly profitable on paper, but weren’t properly recognizing job-site labor or material purchases. Worse still, they were operating on a cash basis. So, costs didn’t materialize until weeks later, long after revenue appeared. The result? They overpaid bonuses, underbid jobs, and burned through cash.

The Real Estate Wholesaler Misreading Margin
A wholesaler thought their profit margin was high because they didn’t include sales compensation and marketing as part of COGS. However, their entire business model relies on generating leads and converting those leads into arbitrage opportunities—acquiring a property under contract at a low price and assigning that contract to an investor at a markup. The margin wasn’t built on service delivery—it was built on smart marketing and aggressive negotiation. Their actual COGS was nearly 65% of revenue. Without properly capturing it, their P&L misled them leading to poor decisions.

Why Small Businesses Skip This (and Why They Can’t Afford To)

Most entrepreneurs are heads-down. They’re busy selling, hiring, and serving clients. Tracking direct vs. indirect labor feels like a luxury.

But here’s the truth: If you don’t separate delivery costs from overhead, your business can’t scale intelligently.

You can’t:

• Set accurate pricing
• Measure real gross margin
• Hold delivery teams accountable
• Forecast staffing needs
• Know when to say yes, or no, to a client

Even worse, many smaller businesses don’t use accrual accounting, especially in manufacturing and construction. That means materials purchased today will be reflected in this month’s P&L, even if revenue won’t be recognized for months.

Imagine this: You’re showing a loss today on a job you won’t recognize revenue on for 90 days; no wonder your financials feel like a roller coaster.

What Belongs in COGS? Let’s Simplify It by Business Type

Manufacturing

Includes:

• Raw materials
• Direct labor (factory line)
• Supplies used in production
• Utilities tied to manufacturing

Excludes:

• Sales & marketing
• Office rent
• R&D (unless product-specific)

Retail/Wholesale

Includes:

• Purchase price of inventory
• Freight-in
• Packaging tied to resale

Excludes:

• Store staff (unless prepping goods)
• Customer service
• Warehousing unrelated to reselling

Real Estate Wholesalers (and Similar Arbitrage Models)

These are service businesses—but not in the traditional sense. They generate profit through arbitrage, not hours worked. Their product is access, negotiation, and speed. The typical wholesaler finds deeply discounted real estate, locks in a seller contract, and then sells that contract to an investor for a higher price, without ever taking ownership of the property.

Their cost of goods sold is heavily tied to performance-based marketing and sales.

Includes:

• Advertising and lead generation costs
• Commissions paid to acquisition and disposition reps
• Transaction-specific closing fees

Excludes:

• General overhead and admin
• Marketing team management
• Office lease, general systems, or executive salaries

Why does this matter? Because 80% or more of the cost structure is variable. If marketing spend isn’t optimized, margins vanish. The entire business depends on two things:

(1) ROI on marketing.

(2) The sales team’s ability to negotiate a spread.

This is COGS, not SG&A. Their margin isn’t built from service delivery; it’s built from arbitrage and conversion efficiency. And misclassifying those direct costs inflates gross profit and sends the wrong signals to leadership.

The “Direct Delivery” Test

If you’re unsure whether an expense belongs in COGS, ask:

Would we incur this cost if we didn’t sell or deliver this product or service?

If the answer is yes, it’s a COGS.
If the answer is no, it’s probably SG&A (Selling, General & Admin).

Final Word: Garbage In, Garbage Out

Your financials are your scoreboard. But if the inputs are wrong, especially COGS, you’re not just playing the wrong game. You’re not even in the right stadium.

Want to know why your cash isn’t tracking with your profit? Start here. Clean up your COGS, adopt accrual accounting, and build a business that actually reflects the value you deliver.

Need help structuring your financial model for growth? Let’s talk.

 

About the Author: Howard M. Shore is the founder and CEO of Activate Group Inc., a business and executive coaching firm that helps growth-minded CEOs and leadership teams unlock their full potential. He is the author of Your Business Is A Leaky Bucket and The Leader Launchpad, which provide frameworks for building scalable systems, strong cultures, and sustainable results. Howard is a member of the Scaling Up, Strategic Coach, and Metronomics coaching communities and has helped hundreds of organizations achieve exponential growth through clarity, accountability, and alignment.