What is Cost of Goods Sold (COGS)?
A key metric in evaluating the efficiency of a company’s products or services is gross profit (or gross margin percentage -- a function of gross profit). It’s a metric that is scrutinized heavily by business owners and outside stakeholders.
The drivers of gross profit are revenue and cost of goods sold (COGS) or cost of sales (COS).
Before we get into how gross profit is calculated, let’s dive a little deeper to understand COGS.
COST OF GOODS SOLD (COGS)
COGS refers to the inputs (in dollars) that are used to create, purchase or service a product that is sold to earn revenue. In summary, COGS costs are ones that are directly related to delivering a product or service to customers.
Most industries have their own methods of calculating COGS (we’ll speak about that below) but the fundamental idea is that there are no other expenses included in the computation of COGS other than the cost of the product itself (i.e. in many industries, rent, marketing, advertising and other overhead costs are not included in COGS since they are not directly attributable to the product or service).
COGS sits on a company’s income statement/profit and loss statement and has a direct effect on net income and a company’s business taxes.
HOW IS COGS CALCULATED
Many industries have their own accepted way of tracking COGS - below are a few examples. We’ll start with ‘manufacturing’ since it’s easiest to understand and most likely where COGS originated.
Manufacturing (including e-commerce)
A manufacturing company calculates COGS by adding all of the costs that helped create the product (i.e. the labour involved, the machine/manufacturing overhead, and of course, the raw materials themselves). Combining all of those inputs for one item (or many) provides you with clarity over a company’s COGS.
Finished Goods (including e-commerce)
Companies that buy finished goods for resale would include all costs associated with procuring finished goods from suppliers. Costs usually include the finished goods themselves plus freight and any other landed costs (i.e. the total cost to bring the item into the company’s place of business (or third-party logistics facility (3PL)) where it’s ready to be sold) - including warehousing itself.
Software as as Service - SaaS
In the SaaS landscape, there’s general agreement on the inputs that make up COGS. It’s also more common to refer to SaaS costs as cost of sales (COS) or cost of revenue (COR) since there are no physical goods actually being produced or sold (just software).
The typical inputs making up COS in a SaaS company are:
Staffing costs for keeping the product serviceable to customers (i.e. customer support, implementation specialists, etc.)
Hosting cost (AWS, Rackspace, Azure, Google Cloud for example)
Subcontractors or other companies directly involved in the ongoing delivery of the product
Third-party software that is sold as part of a SaaS product (i.e. licenses with other software providers, integrators, etc.)
It’s generally accepted that ‘development costs’ - which result in significant costs and resources in a SaaS company - are not included in COS.
In general, if you could deliver your product to customers without a certain cost, then typically you would not include that expense in your COS calculation.
Service-based businesses
In service-based businesses - COS is similar to those in SaaS - since there are no physical goods sold, but rather some sort of service is provided (i.e. accounting/bookkeeping or professional services, legal, project-based services, etc.).
In service-based businesses, expenses related to delivery of the product should be recognized as COS. Most commonly, costs related to salaries/wages and subcontractors make up a significant portion of COS in service-based businesses since there’s less technology, machinery and goods at play.
COGS FOR YOUR BUSINESS
There is no precise or ‘catch-all’ way to calculate COGS for a specific business. There are comparisons that can be made to similar industries and companies (some are noted above) but each business is unique and might require tweaks to their COGS calculations to ensure they’re as accurate as possible when it comes to measuring this critical company metric.
Cost of goods sold is vital to operations since it aims to explain how efficient a company is at selling a good or service. Early on it gives you an indication of whether a business is even viable. If COGS is high and profit margin is low and there’s no effective way to reduce COGS significantly, then it may make sense for a business to pivot.
In scaling companies or mature organizations it provides details over how efficiently costs are being contained, whether further action is warranted (i.e. reaching new deals with suppliers) and whether management is doing a good job at cost containment.
COGS is a tried and tested metric for benchmarking purposes - especially against companies in the same industries - investors and stakeholders are very interested in COGS when analyzing the health of a company.
HOW IS GROSS PROFIT CALCULATED
Revenue minus COGS = Gross Profit
Gross Profit / Revenue = Gross Margin %
The ‘gross profit’ figure in the formula above is provided as an absolute dollar amount while the ‘gross margin’ figure in the formula above is provided as a percentage or ratio.
Comparing gross profit to other businesses might not provide much insights since size and scale differs for every business. But, gross margin percentage is a fantastic key performance indicator (KPI) and one that can be compared to other businesses and industries since it’s measured as a percentage.
The higher your gross profit and margin are, the more efficient your business or your management is at producing profit from every dollar of revenue.
OPERATING EXPENSES
Operating expenses on the other hand are indirect costs (i.e. costs that aren’t directly tied to producing revenue). For example, marketing in most cases is an operating expense since it’s very difficult to tie an ongoing marketing campaign to revenue earned. Other notable operating expenses are rent, professional fees and internal software.
Operating expenses are still crucial to a company’s bottom line as they are deducted from gross profit.
Consensus is that although operating expenses are important, COGS provides a more important metric about long-term viability and profitability.
If you need help analyzing your business or financial statements and determining how to calculate COGS, COS/COR - reach out to us!
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