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Everything Small Business Owners Need to Know About COGS

Many small business owners have come across the concept of COGS, also known as Cost of Goods Sold, and wondered what on earth it means. At My OC Bookkeeper, we’ve encountered this many times, and that’s why we’ve put together our handy guide: Everything Small Business Owners Need to Know About COGS (Cost of Goods Sold). So, if you are a small business owner, or medium business owner, or are just interested in business, grab a cup of coffee and let’s start learning.

What Is Included in COGS?

First things first, let’s start with the basic definition of COGS: the costs of inputs used directly in the production of goods. Examples include raw materials, labor tied directly to production, and overhead tied directly to production. So, the fabric bought and turned into sweaters is included in COGS, as is the labor of the worker who sews the sweaters, and the cost of shipping the fabric.

Why do we care? Well, that depends a bit on the situation, but the general idea is that COGS helps to isolate the true cost of products by including expenses that extend beyond the basic costs of materials.

What Isn’t Included in COGS

Learning what isn’t included in cost of goods sold can be as helpful as learning what is included. In short, general expenses that aren’t directly tied to the production of whatever products that you sell aren’t applicable. Management and sales salaries, amounts paid to accountants, marketing costs, and interest on loans are common examples. These are considered operating expenses, that is, expenses associated with operating a company rather than producing a good. Operating expenses occur further down the income statement (also known as P&L) than COGS, but like COGS are deducted in order to calculate a company’s net profits, or bottom line.

Do All Companies Use Cost of Goods Sold? Why?

Not all companies use COGS when generating their financial information. Those that do are using what is known as gross profit accounting. That is, accounting which calculates gross profits by deducting COGS from revenues at the top of the income statement. (As opposed to not having any COGS category and therefore skipping the gross profit line altogether. (Click here if a refresher on income statements would be helpful.))

The obvious follow up question is, why don’t all companies calculate COGS? Well, for some companies it doesn’t really make sense. Service companies, for example, don’t sell any physical merchandise. If you don’t sell a widget, you can’t calculate the costs used in its production very well can you. Common examples of companies that don’t use cost of goods sold are accounting firms, real estate firms, consulting firms, and companies that do repair work. (A ton of small businesses fall into this category.) Basically, if you don’t hold inventory, than COGS doesn’t make a whole lot of sense.

There are also some companies who prefer to spread their expenses throughout their income statement rather than grouping production expenses together into COGS. When making decisions on matter like this, be sure to consult with a tax professional to make sure you are compliant with all of the relevant rules and regulations. You certainly don’t want to make an accounting mistake that causes you problems down the road.

How Do You Calculate COGS?

Calculating COGS is done using the value of a company’s inventory. It can get rather complicated because there are several different ways of calculating inventory, some of which are accepted in some countries but not others. (For the curious among you, common inventory calculation methods include Last in First Out, First in First Out, the Special Identification Method, and the Average Cost Method.) As this is an introductory lesson, we won’t get too deep into the weeds and will stick with the basic idea. That is, COGS = Beginning Inventory + Purchases – Ending Inventory.

If you break down this equation, you’ll see that it implies that COGS equals the value of the inventory that was sold during the given period. (If we circle back to the fact that COGS includes all of the costs directly associated with producing an item, we’ll see that the value of inventory on a company’s balance sheet represents the cost of creating it, but that goes beyond this lesson.)

Hands holdings hundred dollar bills, symbolic of using COGS to calculate gross profit.
One key thing that small business owners need to know about COGS is that it is used to calculate the gross profit margin. (That’s pretty important, hence the big bills above.)

What Can COGS Teach Us About a Company?

A metric which is often used to analyze COGS is the gross profit margin. The calculation for this is (Net Sales – COGS) / Net Sales. The higher this ratio, the more the company is making for each unit sold. (Ratios are huge in accounting and finance. Click here to learn about liquidity ratios.)

As is the case with most accounting measures, properly analyzing the gross profit margin is all about context. At first glance, a high gross profit margin seems great, but if you are pricing your product too high you might not sell anything. That having been said, if your gross profit margin is too low, you’ll have to sell a ton of products to make any money. In order to account for these issues the gross profit margin is often viewed in conjunction with other metrics, such as net profit, or the number of units sold. Likewise, it can be helpful to compare a company’s gross profit margin to similar companies so you have an idea what is common in the industry.

Another issue to consider is how gross profit margin fluctuates through time. If a company’s margin changes wildly from period to period, it might be indicative of supplier problems, issues in the manufacturing process, or the failure to find a good price point for the products being sold. If the margin is changing regularly, it’s often wise to do a bit more research. Is that normal for the industry or is it just this company? If it’s just this company, what is causing it?

Further Learning

Looking for some advanced training on COGS? Wall Street Prep has some pretty good stuff here. Or, if you want to really dig into COGS along with all kinds of things related to finance, business, and economics, while pushing yourself and picking up a master’s level designation, check out the CFA Institute. I can tell you from experience that taking the CFA exams is a challenging but rewarding experience. Finally, for more info on income statements, check out our introduction to income statements blog post, and for another intermediate accounting concept, check out this article on contra accounts.

Prefer learning from videos? Check out the great clip below on COGS.

Well, there you have it, our handy introduction to Cost of Goods Sold, also known as everything small business owners need to know about COGS. We hope you’ve found this incredibly illuminating and composed with poetic prose. (Or, maybe at least one of the two.)

Who are we? We are My OC Bookkeeper, Orange County’s premier bookkeeping and business consulting firm. If you need help with your books, whether it’s payroll, a bookkeeping cleanup, monthly bookkeeping, or anything else (including financial modeling), we are here to help. Reach out to us today and let’s do great things together.

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