COGS vs Operating Expense for Sales Commissions: What I Learned After 15 Years of Getting This Wrong
After 15 years as a controller and CFO across manufacturing, SaaS, and retail companies, I'm finally ready to share the truth about sales commission classification. Because honestly? Most of what you read online is either theoretical accounting textbook stuff or written by people who've never actually had to defend their choice to auditors, investors, or the CEO asking why gross margins suddenly dropped 5 points.
The Classification Reality Nobody Talks About
Here's what they don't tell you: The "right" answer isn't in any accounting manual. It's a business decision disguised as an accounting rule, and every finance team I know has argued about this at least once.
I've classified commissions as both COGS (Cost of Goods Sold) and operating expense at different companies, and frankly, both choices were "correct" according to GAAP. The real question isn't what's technically allowed. It's what story you want your financials to tell.
What Actually Happens in the Real World
At My Manufacturing Company (2018-2021)
The situation: $150M industrial equipment manufacturer. Sales reps earned 3% to 5% commission on every machine sold.
What we did: Classified all sales commissions as COGS.
Why it worked: Our investors and lenders understood gross margins better when all variable selling costs were included. When equipment sales dropped 30% during COVID, our commission expense dropped proportionally. That's classic variable cost behavior.
The controversy: Our new auditor (Big Four firm) initially pushed back, saying employee commissions should be SG&A. We had to document that commissions were directly tied to specific product sales and varied dollar-for-dollar with revenue.
Reality check: Including commissions in COGS dropped our gross margins from 42% to 38%, but it gave us much cleaner unit economics for pricing decisions.
At My SaaS Company (2021-2023)
The situation: $45M ARR subscription software company. Sales team earned commissions on new bookings plus expansion revenue.
What we did: Classified all commissions as operating expense (SG&A).
Why this made sense: Our investors wanted to see pure product delivery costs in COGS. Hosting, support, infrastructure. Including sales commissions would have destroyed our "SaaS gross margin story" that VCs expect to see.
The political reality: Our board included three former SaaS executives who would have questioned our financial literacy if we'd put commissions in COGS. Industry norms matter more than accounting theory sometimes.
The complexity: Under ASC 606, we had to capitalize and amortize certain commissions anyway, which made the COGS vs. operating expense question almost irrelevant for many deals.
At My Retail Company (2023-Present)
The situation: $200M e-commerce retailer. Commission structure varies by product category and sales channel.
What we're doing: Hybrid approach. Third-party marketplace commissions go to COGS, internal sales team commissions go to SG&A.
Why this works: Marketplace commissions (Amazon, eBay) are truly transactional costs required to complete each sale. Internal employee commissions are compensation expense.
The audit challenge: Our auditors love the logic but hate the complexity. We spend hours each quarter documenting the split.
The Four Classification Approaches I've Actually Seen Work
1. The "Pure Variable Cost" Approach
When it works: Manufacturing, distribution, and physical goods where commissions vary directly with unit sales.
The logic: If commission expense moves dollar-for-dollar with revenue, it behaves like a variable cost and belongs in COGS.
Real example: My former company paid 4% commission on every machine sold. When we sold 100 machines, commission was $X. When we sold 50 machines, commission was exactly $X/2. That's COGS behavior.
The catch: Only works if commissions are truly transaction-specific and you can tie them to individual products or sales.
2. The "Service Delivery" Approach
When it works: Professional services and project-based businesses where sales effort is part of service delivery.
The logic: In consulting or custom software development, the sales process is often part of the overall service delivery. Including commissions in COGS gives better project profitability.
Real example: A consulting firm I advised treated business development commissions as project costs because relationship building was integral to delivering successful engagements.
The limitation: Hard to justify for standardized products or subscription services.
3. The "Industry Standard" Approach
When it works: When you're planning an exit, raising capital, or comparing to public company peers.
The logic: Match what similar companies in your industry do to make financial comparisons easier.
Real example: Every SaaS company I know classifies commissions as operating expense because that's what investors expect to see. Fighting this convention isn't worth the confusion.
The risk: You might be copying someone else's mistake or using an approach that doesn't fit your business model.
4. The "Stakeholder Story" Approach
When it works: When the classification choice helps tell your business story more clearly.
The logic: Choose the method that makes your key metrics (gross margin, unit economics, scalability) most understandable to stakeholders.
Real example: My manufacturing company included commissions in COGS because it helped explain why margins improved during high-volume periods and declined during slow periods.
What Nobody Tells You About the Consequences
Investor Relations Impact
The surprise: Classification affects more than just financial statements. When I moved commissions from SG&A to COGS at the manufacturing company, our gross margins dropped 4 percentage points overnight. The board meeting discussion was... intense.
The lesson: Warn stakeholders before making classification changes, even if the total expenses are identical.
Audit Complexity
The reality: Auditors care more about consistency than the specific method you choose. I've never had an auditor reject a commission classification if we could document the rationale and apply it consistently.
The gotcha: Changing classification methods mid-stream creates way more audit work. We spent $15K in extra audit fees the year we switched approaches.
Management Reporting Chaos
The hidden cost: COGS classification requires more detailed tracking. At the manufacturing company, we had to allocate commissions to specific products for accurate gross margin analysis. The administrative burden was significant.
Loan Covenant Implications
The surprise: Our bank loan had gross margin covenants. When we reclassified commissions to COGS, we almost triggered a covenant violation. Always check your debt agreements before making classification changes.
Red Flags I've Learned to Watch For
The "Best of Both Worlds" Trap
What happens: Some companies try to classify commissions differently for different purposes. COGS for pricing decisions, SG&A for investor presentations.
Why this fails: Creates audit issues and stakeholder confusion. Pick one method and stick with it.
The "Allocation Nightmare" Problem
The scenario: Trying to split shared commissions between COGS and SG&A based on complex allocation methods.
Reality check: If you need a spreadsheet with 47 formulas to calculate commission classification, you're overthinking it.
The "Industry Exception" Justification
The trap: Believing your situation is so unique that normal rules don't apply.
What I learned: Every CFO thinks their business model is special. Usually, one of the standard approaches works fine.
My Honest Recommendations
For Manufacturing/Physical Products:
Go with COGS if commissions are product-specific and truly variable with unit sales. Your gross margin analysis will be much cleaner.
For SaaS/Subscription Businesses:
Stick with operating expense. Every investor, auditor, and industry analyst expects this. Don't fight convention unless you have a compelling reason.
For Professional Services:
Consider your business development model. If sales effort is part of service delivery, COGS makes sense. If it's separate from project work, use SG&A.
For Retail/E-commerce:
Split by channel if feasible. Marketplace commissions (Amazon, etc.) belong in COGS. Internal sales team commissions go to SG&A.
For Everyone Else:
Pick the method that tells your business story most clearly and can be consistently applied without administrative nightmare.
The Bottom Line Truth
After 15 years of fighting this battle, here's what I wish someone had told me: The classification choice matters way less than applying it consistently and being able to explain your reasoning.
I've seen companies succeed with both approaches. I've also seen companies waste months debating this decision while missing more important financial management issues.
My rule: Spend 80% of your time getting commission calculation and payment processes right, and 20% worrying about classification. The operational stuff affects your business way more than which line item commissions appear under.
Final reality check: If you're spending more than two board meetings discussing commission classification, you're probably overthinking it. Pick an approach that makes sense for your business model, document the rationale, and move on to more important financial decisions.
The most successful CFOs I know made this decision quickly and spent their energy on commission plan design, sales efficiency metrics, and customer acquisition cost optimization. That's where the real business value gets created.
