An important aspect of small business growth planning is understanding and managing your cost of goods sold. Whether your business sells products or services, it’s important to know “what is the cost of goods sold?” for each item or service you sell. This number provides the basic information you need to promote small business growth.
Understanding Cost of Goods Sold Can help your business make sound financial decisions. If growing your small business is your priority, then make certain you have calculated your expenses and all of your costs.
1. What is Cost of Goods Sold?
Cost of Goods Sold or COGS puts a number on your actual costs of goods and services. This number is associated with both physical items as well as services offered by your staff.
Even when you’re not selling, what you sell is costing you money. When you learn how to determine cost of goods sold for your small business, you get this exact dollar figure.
COGS appears on your profit and loss statement and helps you calculate net income. It is also the largest expense at many companies, so learning to manage COGS can help you with revenues, business growth planning, and with just about every financial decision at your company.
Knowing your Cost of Goods Sold can help you make key decisions about your business.
For example, if you want to seek financing interest can increase your COGS. Knowing what the current costs are can help you determine whether you can afford another loan.
If you are pricing a product or considering price increases, COGS can help you understand how much you need to charge to make a profit.
Calculating Cost of Good Sold is a strategic part of small business planning along with working directly with a bookkeeper and business growth advisor.
You don’t need to be a mathematician to calculate COGS. The calculation for COGS is easy:
starting inventory + purchases of inventory - end inventory
For example, say you have 100 writing journals in your shop and you create 100 more. You have an end inventory of 150. This means the total number of journals you have sold is 50.
Once you know that, you can determine how much it costs to create each journal, so you can determine COGS. There are three ways of doing this:
- First In, First Out (FIFO): In this evaluation, you assume the latest products in your inventory are the ones selling or being put out for sale first.
- Last In, First Out (LIFO): In this evaluation, you assume the older items sold first. This can be especially true with perishable goods.
- Average Costs: This determines an average price per unit. To calculate this, you add purchases in dollars and the beginning inventory. You divide the number you get by purchases in units plus beginning inventory. This gives you the average cost per unit. Once you have this number, subtract the number of units you have sold to get COGS.
As one of the more common bookkeeping questions we hear, the difference between Operating Expenses (OE) and Cost of Goods Sold (COGS) is a fairly straightforward one, but it plays a significant role when it comes to allocating and analyzing the resources you spend to make your business profitable.
While both OE and COGS are considered expense accounts from a bookkeeping point of view, they’re separated on the income statement to differentiate between money that’s spent to keep your company running, and money that’s associated with providing your company’s product or service.
In the case of a service industry, the term Cost of Sales (COS) is often used rather than Cost of Goods Sold since there are no physical goods involved, but for the purposes of this discussion, we’ll be using the generic term COGS.
What's The Difference?
Understanding the difference between regular operating expenses and COGS begins with recognizing two important facts:
- The terms "expense" and "cost" don’t always mean the same thing.
- All expenses are not created equal.
An expense is a cost of doing business, but a cost is not necessarily always an expense. The easiest way to illustrate the difference between these expenses and costs is to look at a simple example.
Example of Expenses vs. Costs
Let’s say your company sells souvenir widgets to passing tourists from a truck on the street. You have a pretty good idea of how many widgets you usually sell in a day, but you never want to risk a lost sale, so you always buy a few extras when you purchase your supplies each morning.
If you spend $500 on today’s batch of widgets, but you only end up selling $400 worth of them:
From an accounting point of view, an expense is something that’s used up, or consumed, during the normal course of your business operations.
The $100 worth of widgets that you didn’t sell today, while still representing a cost to your business, won’t become an actual expense until they’re sold on some other day.
Don’t get too hung up on the name. Any business cost directly related to the sale of your product or service becomes an expense once it’s been allocated to a sales transaction, even though it’s still referred to as a cost of goods sold.
Every business has operating expenses, but whether or not those expenses can be classified as COGS depends on whether or not they’re directly related to the sale of a product or service. The terms direct and indirect are often used to differentiate between money that’s spent to:
- fund the purchase or manufacturing costs of goods or services being sold – such as raw materials or inventory, packaging, sales or manufacturing labor, or shipping (direct);
- keep a business running – such as rent, insurance, utilities, or administrative wages (indirect).
One way to figure out which is which when it comes direct and indirect expenditures is to ask:
Would this still be considered an expense even if a sale had not occurred?
If the answer is no, as it would be for the purchase cost of our vendor’s widgets, then they probably fall into the direct, or COGS category.
If the answer is yes, as it would be for the insurance on our widget-vendor’s truck, then they’re most likely an indirect operating expense.
So, where does all of this land us when it comes to managing our books?
Outsourcing your small business bookkeeping allows you to let someone else worry about the answer to that question.
But for the sake of staying in the loop where your business accounts are concerned, the basic entries would look like this:
- When you incur an indirect expense, such as rent or insurance, your bookkeeping entry would debit the appropriate expense account and credit accounts payable.
- When you incur a direct cost, such as inventory, your entry would debit the appropriate asset account and credit accounts payable.
- When inventory is subsequently sold, it becomes an expense, so your entry would credit the asset account and debit its correlating COGS account for the same amount.
If you’d like someone to calculate COGS for you, handle bookkeeping or help you with consulting or related support, contact SLC Bookkeeping. Our professional bookkeeping and small-business consulting services take the guesswork out of business management and bookkeeping. We focus on business growth strategies so you can increase revenue and expand your business.
[Original post date: 01/25/2017] Comments in the comment section may be dated before the revised publish date of this article.