How do I define my cost of goods sold (COGS)?
What is COGS?
An important income statement metric to determine profitability is cost of goods sold, or COGS. This little financial term isn't just to satisfy your own curiosity—your COGS, subtracted from your revenue, determines what you owe in taxes at year end and what any investor will ask you when doing due diligence. "Delight your investors: know & manage COGS so you can expand gross margins. It never hurts to be accused of good management," notes Devon Pennington, portfolio manager of Brightlights Capital.
Failure to define this critical figure can hurt you outside of tax season, too: you might suffer the paradox of losing more money as you sell more goods if you’re not keenly aware of your costs. "Breaking down COGS by product and product line is the first step in choosing your company´s product mix," says Pennington. Without clear gross and contribution margins, you can´t decide what SKUs to keep, cut, or add and without COGS you don´t know your gross margin."
For companies selling software or services, COGS is not necessarily the correct metric to use when thinking about your "costs." Scroll to the bottom of this piece to see why.
COGS consists of costs that are directly attributable to specific revenue generation. Many businesses can use a simple rubric to define the expenses that qualify to fall under the COGS umbrella.
First, COGS includes all of the costs and expenses directly related to the production of goods you will sell later.
Second, COGS excludes indirect costs such as office overhead, sales & marketing, etc. that you use to sell the product, support the product, or do anything else except make the product, if you cannot directly attribute them to the revenue generated.
For instance, if you owned a lemonade stand, you wouldn´t include money spent on advertising around the neighborhood or on Facebook since you usually wouldn’t be able to tell whether a customer bought lemonade because of the advertising, or because they just happened to pass by. You would include the cost of lemons, water and sugar—things that were directly a part of production.
The IRS also allows inclusion of expenses that were "indirectly" part of production—for instance, if you paid rent on the lemonade stand where you make the lemonade, you might include a portion of it, as well as the wear and tear of your lemon squeezer. An accountant is essential in identifying and correctly calculating these indirect expenses—they're not always evident and always seem to show up in part of your overhead, i.e. your support expenses that have been directly diverted or allocated for production. So yes, that means only the part of the lemonade stand you use to make the lemonade counts for COGS.
A good rule of thumb is "would I have made this expense had I produced nothing?" If the answer is yes, the expense is usually not part of COGS, but more properly attributed to sales, general and administrative (SG&A) expenses.
We're not quite done yet, though. We've identified and calculated the costs associated with production. But to be truly useful, COGS relies on a simple formula to tell the full story of your total COGS across all of your inventory across a period of time:
Starting inventory value + purchases related to production - ending inventory value = COGS
To see how this applies, going back to our lemonade stand, you might start a week with $50 worth of product from the week prior. You then purchase $50 worth of lemons, sugar and distilled water that week for more lemonade. Thanks to a heat wave, you end the week with only $10 worth of lemonade. Your cost of goods sold, then, was $90.
If you sold $100 of lemonade that week, your profit would be $10.
Of course, COGS is more complicated in real life situations. Often, your starting and ending inventory values can differ if component prices—also known as input prices for the reseller—differ from period to period. For instance, if sugar is suddenly cheaper and you only spend $30 on lemons, sugar and water, your profitability increases by $20 even though nothing else changes. And the following period's inventory was also cheaper in terms of investment it represented — which would, of course, boost profitability even if you sold the same amount of lemonade. More expensive sugar would have the opposite effect.
This can be an issue when products have longer "shelf" lives and can intermingle within the inventory. When a computer chip company pays more for silicon (its raw material, a component of COGS) than it did in the past, its COGS will vary based on whether it considers the oldest raw materials it has purchased first (called "First In, First Out", or FIFO), or the newest ones first ("Last In, Last Out", or LIFO).
To combat this fluctuation, you might average costs out across all products and maintain a steady COGS that might not reflect the "true" COGS at a moment in time but does reflect the "true" COGS over a period of time.
All of these accounting approaches have their advantages and disadvantages, and will require an accountant and sound accounting policies to calculate and tell you which is most useful to you. Your choice will affect the timing of your tax bill as well as the profitability shown in your income statement.
Cost of Goods versus Cost of Services
COGS generally is a tool for founders whose businesses produce and sell physical goods—think consumables, clothes, industrial machines, commodities. Many startup founders, however, run businesses which either provide a service or software, or provide service and software alongside a physical product that has its own COGS. Here, estimations can get a little more complex, but the concept doesn´t change. For instance, hosting fees (like Amazon Web Services) and merchant fees (like Stripe) can be considered part of your service costs, though it may require an accountant to figure out the exact breakdown.
However, engineering or development costs for software, for instance, are not considered COGS—rather, they're non-recurring engineering (NRE) expenses, which is why software companies have famously low COGS despite employing legions of programmers. There are ways to account for these items on your balance sheet in a way that's both accurate and advantageous come tax season, usually via an R&D tax credit.
At Paperclip, we focus on providing accounting that zeroes in on what's useful to founders and necessary for enabling you to enjoy strong tax advantages, all while providing detailed and industry-standard accounting. Talk to us today about better understanding the real costs,and opportunities, for your business.
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How do I define my cost of goods sold (COGS)?
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