Business model & unit economics
How to build a cost of goods sold model that accurately captures direct and indirect costs for precise unit economics.
This evergreen guide reveals practical steps to construct a robust COGS model, distinguishing direct material and labor from indirect overhead, enabling clear profitability insights, pricing decisions, and scalable growth.
August 06, 2025 - 3 min Read
A reliable COGS model starts with a precise definition of what counts as cost of goods sold in your business. Begin by separating direct costs tied to production from indirect costs that support operations but do not vary with each unit sold. Direct costs include materials, packaging, and labor directly involved in making the product. Indirect costs, sometimes called overhead, cover rent, utilities, depreciation, and certain administrative expenses. The challenge is to allocate shared resources fairly across units, so the numbers reflect reality rather than guesswork. As you map out costs, document assumptions, data sources, and measurement methods. This transparency will help stakeholders understand margins, forecast profitability, and adjust pricing or processes when conditions change.
A well-structured COGS model also requires consistent cost allocation rules. Decide whether to use job costing, activity-based costing, or a hybrid approach that fits your business model. Job costing assigns costs by batch or order, which works well for customized products. Activity-based costing links expenses to activities such as procurement, setup, or inspection, offering more granular insight into where value is created or wasted. Whatever method you choose, apply it uniformly across periods to enable meaningful trend analysis. Build a concise chart of accounts that mirrors the logical flow of costs from suppliers to finished goods. Regularly review allocations to ensure they reflect current operations and demand patterns.
Tie every expense to a measurable driver that informs pricing decisions.
The next step is to quantify each cost category with disciplined budgeting. Start with materials and direct labor, calculating unit costs by dividing total spend by the number of units produced. Then assign overhead using a chosen allocator—such as machine hours, labor hours, or square footage—to reflect how much each unit consumes of shared resources. Record variances between estimated and actual costs, investigating the drivers behind them. This practice helps prevent creeping inflammation in margins and highlights opportunities to renegotiate supplier terms, adjust production schedules, or alter product design. A transparent variance program also supports accountability across teams and strengthens strategic decision making.
In addition to allocating overhead, capture ancillary costs that affect unit economics but may not be obvious at first glance. Consider costs like quality assurance, returns processing, guarantees, and after-sales support that are triggered per unit. These expenses can dramatically influence true profitability if left hidden or underestimated. Segment them by channel or customer group to determine where they hit most heavily. Pair every cost line with a corresponding driver to ensure traceability. By creating this link, you gain the ability to test what-if scenarios, such as changing packaging to reduce damage rates or shifting service levels to balance cost and customer satisfaction.
Use pilot tests to verify accuracy under changing volumes and conditions.
A practical COGS model uses driver-based cost drivers to connect costs with activities. List the key activities required to produce and deliver your product, such as procurement, manufacturing setup, and packaging. For each activity, assign a driver count—for example, number of purchase orders, machine setups, or packaging runs. Multiply the driver count by the unit rate you established for that activity to obtain the activity cost per unit. Summing all activity costs with direct material and direct labor yields a total COGS per unit. This approach helps you see precisely which activities scale up or down with volume and where efficiency gains will have the greatest impact on margins.
When you complete an activity-based breakdown, validate it with real-world tests. Run pilot productions at different volumes and track actual costs against the model’s predictions. If discrepancies occur, refine driver rates, reallocate overhead more accurately, or adjust input prices. The goal is to converge on a model that consistently mirrors observed costs across multiple scenarios. Document these validation cases so future planners can reproduce results or adapt them quickly. A credible COGS model should withstand audits, support price negotiations, and inform capital investments like new equipment or optimized workflows.
Cross-functional collaboration keeps the model current and relevant.
Beyond the mechanics of calculation, the business context matters. A COGS model is most powerful when aligned with strategic goals—whether you pursue volume growth, premium positioning, or cost leadership. If pricing depends on per-unit margins, ensure the model captures seasonal demand, capacity constraints, and supply risk. Integrate the COGS view with revenue forecasting, so you can project gross margin under different price points and volume scenarios. This foresight helps leadership make informed bets on product mix, channel strategy, and marketing spend. When the model reflects strategic priorities, it becomes a practical decision support tool rather than a static spreadsheet.
Collaboration across departments strengthens model quality. Involve procurement for accurate supplier costs, operations for production realities, and finance for accounting alignment. Establish a recurring cadence—such as monthly reviews—where teams challenge assumptions, update data, and incorporate market changes. This collaborative process also surfaces inefficiencies, like supplier lead times or batch-size constraints, that directly affect unit economics. By maintaining open channels for feedback, you ensure the model stays current and relevant as the business evolves. The result is a living framework that guides pricing, budgeting, and investment choices.
Clean data, governance, and scenario testing drive reliable outcomes.
Integrate the COGS framework with product development. When designing new items, forecast the impact on direct costs, overhead allocation, and required capital equipment. Early cost visibility helps you decide whether a concept is viable at target price points. It also encourages smarter design choices, such as modular components that simplify assembly or standardized packaging that reduces handling costs. By embedding cost awareness into the product lifecycle, you prevent margin erosion later and accelerate time-to-market without sacrificing profitability. This proactive approach supports sustainable growth rather than reactive pricing fixes.
Maintain data quality to preserve model integrity over time. Collect cost data from reliable sources, validate entries, and automate data imports where possible. Minimize manual re-entry to reduce errors and ensure consistency across periods. Establish controls to prevent unauthorized changes and create an audit trail showing how numbers arrived at each conclusion. Regular data hygiene—eliminating duplicates, updating outdated supplier quotes, and reconciling invoices—keeps the COGS model credible. With clean data, scenario testing remains meaningful and your decisions stay grounded in reality.
Finally, translate a complex COGS model into actionable insights for leadership and teams. Present clear per-unit cost figures, highlight major cost drivers, and illustrate how changes affect gross margin. Use visual dashboards that show sensitivities to price, volume, and input costs. Communicate both the upside and the risk embedded in different strategies, so stakeholders understand trade-offs. Provide practical recommendations—like renegotiating supplier terms, adjusting product design, or changing service levels—that can be implemented in the near term. The objective is to empower decision makers to optimize profitability without compromising quality or customer value.
As you institutionalize the model, document the methodology, assumptions, and responsible owners. Create a reference playbook that others can follow when costs shift or new products enter the portfolio. Schedule periodic refreshes to capture evolving supplier dynamics or changes in demand. The enduring value of a robust COGS model lies in its adaptability—the ability to map costs, forecast margins, and guide strategic choices in a way that scales with your business. With disciplined practice, precise unit economics become a sustained competitive advantage.
