Everything Small Business Owners Need to Know About COGS

Women working on an assembly line, symbolic of the concept of 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.

What is the Difference Between Cash Flows and Profits?

A zoomed in photo of Ben Franklin on a dollar bill, symbolic of the importance of understanding how cash flows and profit are not the same.

Cash flows and profits are financial metrics that are crucial to business success. And people, especially those new to finance and accounting, can confuse the two terms. But cash flow and profit are not synonymous.

You must understand the difference between these terms to run your business successfully. You can jeopardize the financial health of your business if you constantly mix up cash flow with profit.

If you are an investor, understanding cash flows and profits can make it easy to spot a good investment. As a business owner, you can skillfully make crucial decisions and identify growth opportunities.

Let’s find out everything you need to know about cash flows and profits, how they are different, and how they can affect your business.

What is Profit?

Profit is what remains after subtracting all the expenses from revenue. If you are making a profit you are making more money than you need to run your business.

Like cash flow, profit can also be positive or negative. To help you calculate your profit, you need to figure out your total revenues, costs, and total expenses. These three numbers determine whether there is net profit or net loss. (By costs we mean costs of goods sold, or costs of sales. If you don’t know what those are, don’t worry, you can just consider them another expense, or check out this great post on COGS to learn more.)

Subtract your costs and expenses from your revenues. If your profit turns out to be a negative number, your business has sustained a loss. This situation means you are spending more than you are gaining. If the number is positive, you are netting a profit. 

There are three different forms of profit.

  • Gross profit is your revenue minus the cost of products sold, also known as COGS.
  • Operating profit is the net profit generated from your core business operations. It does not include deductions from interest and taxes.
  • Net profit is the amount left after subtracting all operating costs, interests, and tax expenses over a given period. It is the result of deducting your total expenses from your total revenue.

Given this equation, you can deduce that your product price and the costs it takes to produce it are two important components involved in determining your gross profit. 

How you manage your expenses has a considerable impact on the outcome of your business. Evaluate your expenses if your net profit isn’t big enough, or worse, you’re not netting a profit. From there, you can improve your company’s profitability.

Proper pricing could also help increase your profit. You can switch vendors or reduce your employee salary to control your costs, but it is the price that you have total control over. The bigger the difference between your product price and the cost of production, the bigger your gross profit. Find the highest possible price that will not scare off your customers.

What is Cash Flow?

Running a successful business requires you to follow numerous rules. But if there is one rule you must stick to, it would be to never run out of cash. It is extremely important to maintain an adequate cash balance, but unfortunately, many business owners and managers ignore this issue until it is too late.

Cash flow is the net balance of cash going in and out of your business at a given point in time. It can either be positive or negative. Negative cash flows means that your business has more money going out than going in. Positive cash flows suggest that you have more money coming in than going out. Positive cash flow gives you the ability to pay loans, pay expenses, and have a buffer in case of financial challenges in the future.

It is necessary to manage cash flow for daily operating costs, purchases, salaries, and tax payments. You must control cash that moves in and out of your business and know how well your cash balance stands against cash demands. (The statement of cash flows is the financial statement that provides info on the cash that is coming in and out and what it is being used for.)

It’s never safe to assume that cash will always be available as long as you are making a profit. If you don’t monitor and control your cash flow, you may find yourself in a serious bind.

An extremely anxious man squeezing his head, indicative of how not understanding the difference between cash flows and profit can hurt business.
If you don’t understand the difference between profits and cash flows your business might be in serious trouble. Don’t be like this guy!

This is one of the reasons why many product-based startups face money issues. A business that sells products has to spend cash first, whether for buying the product or for getting raw materials. Even if the product has the potential to bring in enormous profits, if the startup does not have enough cash, it will not survive.

​​It can be confusing when you are running out of cash, yet your startup is making money. Experienced business owners will tell you that it’s possible to be making strong profits yet not have enough cash.

This scenario happens because each sale adds to your revenues, and therefore profits (see above); however, sales don’t translate into cash flows until you get paid. So, if you are making sales like crazy and creating products like crazy to satisfy the demand but not getting paid quickly enough you may run out of cash and not be able to pay things like rent and salaries. That is a big problem, to say the least.

With this in mind, “Don’t focus on sales,” is sound advice. Sales are important, but cash is king.

But it’s important to remember that cash flows don’t just come from sales. Cash flows can come from various sources. If you get a loan, that is a source of cash flows. If you sell a piece of equipment, that is a source of cash flows. If you finally get paid on a sale you made a year ago, that is a source of cash flows. If you sell equity to some new investors, wait for it, that is a source of cash flows.

So, in summary, cash flows and profits are not the same thing. Profits are what is left over after you deduct all of your expenses / costs from your revenue, but that doesn’t necessarily translate to cash. Cash flows are a separate phenomenon independent from profits, and represent the actual net amount of cash in and out of the business. To run a successful business you must mind both.

Want to learn more? Check out our handy definitions page here, or, to keep pushing your accounting knowledge to new heights, try this great post on contra accounts. (They’re cool, believe us…)

Who are we? We’re My OC Bookkeeper. Orange County’s premier bookkeeping and business advisory firm. (We also really understand cash flows…) No matter what kind of business you run we can serve as your back office so you can focus on the front. Reach out to us today and let’s do great things together! Watch the video below to learn more.