Profitable Pricing Starts Here: How Service Businesses Can Master Cost of Goods Sold (COGS)
Understanding your true service costs is the first step toward smarter pricing, higher profits, and financial clarity. Here's how to master COGS in your service-based business. – Freepik/dcstudio
In the world of service-based businesses, whether you're managing a marketing agency, designing client strategies as a consultant, running a wellness practice, or juggling freelance design gigs, your success hinges on far more than just great service. One of the most critical yet often overlooked aspects of financial health? Knowing your numbers, and specifically, your Cost of Goods Sold (COGS).
Most service providers intuitively understand revenue: invoice clients, and get paid. But when it comes to tracking the direct costs associated with delivering that service, things can get murky. After all, you’re not selling physical products. So, do you even have a cost of goods sold?
The short answer: yes. And if you're not calculating it correctly, you're leaving profit on the table.
In this article, we’ll break down what COGS really means for service-based businesses, how to identify and track it accurately, and, most importantly, how to use it to price more strategically, plan better, and boost your bottom line.
What Is COGS, Really?
Cost of Goods Sold refers to the direct costs involved in delivering your product or service. For product-based businesses, it’s easy to grasp: materials, packaging, manufacturing, and shipping. But in a service-based business, where “goods” are intangible, identifying COGS requires a more nuanced approach.
For service businesses, COGS typically includes:
Direct labor: What you pay employees or contractors who directly perform the service.
Materials used to deliver the service: Think printing for a design studio, third-party tools or licenses, or supplements for a wellness coach.
Subcontractors or freelancers whose time is billable to a specific client or project.
Resold goods that are part of your service deliverables.
COGS does not include general operating expenses like rent, internet, your Zoom subscription, or administrative salaries. These are overhead costs and should be tracked separately to avoid muddying your financial data.
Why Tracking COGS Matters More Than You Think
Too often, service providers group all business expenses into one big category, making it hard to see what it actually costs to deliver their services. But tracking COGS accurately provides three big advantages:
1. You Can Price With Precision
Once you know what it costs to fulfill a service, you can set pricing that not only covers your expenses but leaves room for a healthy profit margin.
Let’s say it costs you $2,000 in labor and tools to deliver a $5,000 marketing package. That’s a 60% gross margin. But if you didn’t account for those costs or misclassified them, you might incorrectly believe you’re making more than you are. Accurate COGS gives you the confidence to price intentionally and sustainably.
2. You’ll Unlock Tax Benefits
COGS is a deductible expense. That means every dollar you accurately categorize as COGS directly reduces your taxable income. If you’re misclassifying COGS as general expenses or not tracking it at all, you could be missing out on legitimate tax deductions.
Even more importantly, many tax authorities require that COGS be reported separately. Having clear, clean records makes filing easier and audit-proof.
3. You Get Real Visibility Into Profitability
Gross profit, your revenue minus COGS, is one of the most important metrics for any service business. It tells you how efficiently you're delivering services and whether your business model is truly profitable. Once you’re regularly reviewing gross profit, you can start optimizing for it: cutting unnecessary costs, adjusting rates, or rebalancing client load.
What Counts as COGS in a Service Business?
This is where many business owners get tripped up. Because services are intangible, the line between “direct” and “indirect” expenses can feel blurry.
Here are a few examples tailored to specific service-based industries:
Marketing Agencies: White-label vendors, freelance designers on client projects, ad spend passed through to clients.
Coaches & Online Course Creators: Guest experts delivering paid content, paid platforms hosting course materials.
Consultants: Billable subcontractors, software tools billed directly to clients, specialized reports, or data access.
Wellness Professionals: Supplements resold to clients (COGS), oils or materials used during treatments (possibly COGS), decor or ambiance (not COGS—overhead).
Creative Studios: Printing, props for photoshoots, licensed music, or stock footage specific to a client project.
Keep in mind:
If it’s required to deliver the client’s service and varies depending on how much you sell, it’s likely COGS.
If it’s part of running your business, regardless of how many clients you have, it’s probably overhead.
Still unsure? That’s where working with a skilled bookkeeper (ideally one familiar with your type of business) comes in handy.
Internal Use vs. Resale: A Critical Distinction
Many service businesses also purchase items that straddle the line between COGS and overhead. For example, a health coach might buy supplements. If those supplements are resold directly to clients, they count as COGS. But if they’re used internally (say, as part of a complimentary in-session protocol), they become an operating expense.
The same rule applies across industries: resale = COGS; internal use = overhead.
Classifying these properly is key to keeping your financial reports accurate and your tax deductions optimized.
How to Track COGS Effectively
You don’t need a massive tech stack to start tracking COGS accurately. But you do need a few basic processes in place:
1. Separate Expense Categories
In your bookkeeping software (like QuickBooks, Xero, or Wave), set up distinct accounts for COGS and for operating expenses. Your chart of accounts should clearly distinguish between:
Direct labor
Materials and supplies
Subcontractor payments
Resold goods
2. Project-Based Tracking
For service businesses, job costing can be a game-changer. This means tracking income and expenses by client or project. Not only will you see which projects are most profitable, but you’ll also be able to optimize pricing, staffing, and resource allocation.
3. Use Time-Tracking Tools
If you rely on contractors or hourly employees, using time-tracking tools can help allocate labor costs directly to projects. Apps like Harvest, Clockify, or even built-in time features in your project management software can do the job.
4. Work With a Bookkeeper Who Gets It
A good bookkeeper can help you set up your systems to track COGS properly, spot misclassifications, and generate clear reports. Ideally, they’ll also partner with your CPA or fractional CFO to ensure your tax strategy aligns with your operational reality.
Making COGS Part of Your Growth Strategy
Once you’ve nailed down your COGS tracking, you can use it to make smarter decisions across your business:
Raise prices strategically based on cost increases.
Improve margins by renegotiating vendor rates or replacing inefficient contractors.
Forecast growth by understanding how your COGS scales with revenue.
Plan hires or scale operations based on actual profitability, not assumptions.
It’s not just about being tax compliant. It’s about being profit-confident.
Final Thoughts: Profit Starts With Clarity
Running a service business comes with unique challenges, especially when it comes to finances. But mastering your COGS is one of the most powerful steps you can take to understand your business at a deeper level.
Whether you're a creative studio scaling up, a digital freelancer tightening margins, or a consultant looking to raise your rates, understanding the true cost of your services empowers you to price smarter, plan better, and grow with confidence.
Ready to bring more clarity and control to your numbers?
Our team specializes in supporting service-based businesses just like yours, from bookkeeping and financial reporting to A/R, A/P, and fractional-CFO guidance.
Let’s talk about how we can help you unlock greater profitability and peace of mind.
