One of the more common bookkeeping questions we hear is about the difference between Operating Expenses (OE) and Cost of Goods Sold (COGS).
While this distinction is fairly straightforward, it plays a significant role in 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 spent to keep your company running and money spent to directly support the costs associated with providing your company’s product or service.
In the 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.
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.
Expenses vs. Costs
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 two terms is to look at a simple example.
Suppose 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:
- the cost of your widgets is $500;
- $400 of that amount constitutes an expense; and
- the remaining $100 constitutes an asset.
From an accounting point of view, an expense is 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 allocated to a sales transaction, even though it’s still referred to as a cost of goods sold.
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Direct Expenses vs. Indirect Expenses
Every business has operating expenses, but whether or not those 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 determine which is which when it comes to direct and indirect expenditures is to ask whether they would still be considered expenses 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.
Tracking Your OE and COGS
So where does all of this land us when managing our books?
If you outsource your bookkeeping, you can let someone else worry about the answer.
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 will debit the appropriate expense account and credit accounts payable.
- When you incur a direct cost, such as inventory, your entry will 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.
