If you review your profit and loss statement each month, you will see that COGS holds a prominent place right below revenue. COGS, or “Cost of Goods Sold” are direct expenses incurred in the production of your company’s goods or services, and are a key component of gross margin. COGS are also known as “Cost of Sales” or “Cost of Services.”
Typically, you will book COGS in the same period you recognize revenue to recognize revenue and profit (or loss) in the same period.
The most common items captured in COGS are direct materials, direct labor, overhead, and supplies. What is not included as part of COGS are the costs of selling, general and/or administrative expenses (SG&A); these are usually in their own subsection below COGS on your P&L statement.
Let’s break down the sections to understand COGS better:
- First, direct materials are the only part of COGS that are a variable expense, which will fluctuate in proportion to revenue. If you expect widget sales to increase because of the upcoming holidays, then the cost of materials will increase as well.
- Next is direct labor. Direct labor includes anyone producing the product or service. This does not include sales staff, but could include temp help if you suddenly have a surge in production, or a contractor 100% dedicated to a product or service. Direct labor is a fixed cost: you generally have the same staffing levels to produce the widgets. Another key component is overhead, which is primarily factored in when you have a dedicated factory or area for production. For service-based businesses, this is typically a fixed percentage of rent, utilities, maintenance, and other costs related to running the business. Overhead is not always considered in the COGS group. Some people want to keep things simple and don’t feel the need for granularity in looking at COGS costs.
- Last is supplies. Supplies are anything used towards the product or service for your customer. If you produce a report for clients as part of your service and present it in a customer binder or folder with tabs and exhibits, the report falls under supplies. As with overhead, not every business includes supplies in COGS.
Once you have determined what items will make up your COGS category and arrive at the total expenses for the period, you’ll get some very useful numbers. The first is your gross margin. You can calculate gross margin by subtracting total COGS expenses from total revenue. The resulting gross margin shows the amount of profit retained after all costs associated with producing your product or service. You can take it a step further and divide the gross margin by revenue to obtain a percentage. The result is your gross profit margin ratio.
For example, if your revenue is $100K, and total COGS are $30K, your gross margin is $70K. In this case, your gross margin ratio is 70%. This means that for each dollar of revenue, your company has earned 70c in profit to apply other costs such as selling, general and administrative expenses.
In the next “Back to Basics,” we’ll dive further into gross margin and why it’s one of the three most important ratios on your financials.
If you need help in breaking down or better understanding your cost of goods sold, your CSM is available to help on this topic or any other part of your financials. Have a question now? You don’t have to wait until a month-end review call! We welcome your call at any time.