As a small business owner, it can be challenging to create a best-in-class service without sacrificing your profitability goals. Calculating and tracking the right metrics can help you achieve this delicate balance.
One of the best metrics for this is Cost of Goods Sold, or COGS. We've put together this article to tell you what it is, how to calculate it, and why tracking it will help you take the next step toward your business goals.
Keep reading to learn more.
What is the Cost of Goods Sold? (COGS)
Cost of Goods Sold is an expense that is directly related to the income that your business produces. Cost of Goods often includes manufacturing costs, materials to create the item, and more if you're selling a product. For service-based companies, COGS can be a little more difficult to define; this may include software costs, service and hosting fees, or general materials. Overall, Cost of Goods expenses may consist of any of the following data points:
- Freight costs
- Sales commissions
- Storage costs
- Purchase returns and allowances
- Other expenses directly related to what your company sells
It's essential to keep in mind that some expenses do not get recorded as COGS expenses. Things like rent, the purchase of a new machine, and general marketing costs do not qualify as COGS because they're not directly related to the product or service you're selling to customers. Instead, these things are general and administrative expenses.
Why Tracking Your Cost of Goods Sold Matters
Cost of Goods Sold is an essential component of accurate accounting that can help your company better understand how much it's spending to create things that generate income.
Understanding Your Profitability
Accurately understanding COGS can lead to numerous benefits, but the most significant benefit is a deeper understanding of your product's profitability. When you don't have data on exactly how much your products and services cost to produce, you have no way of truly knowing whether your company is making a profit on what you're selling. When a business accurately tracks COGS, the profit you earn on what you sell becomes clear. This allows you to evaluate how to introduce new products or increase your profit margin.
Discovering Your Breakeven Number
Understanding Cost of Goods Sold is crucial for figuring out the minimum price your company needs to charge to break even. Understanding your breakeven number is essential to determine the optimal prices for your products or services.
Breakeven allows you to identify the amount of money your business needs to remain operational. This is incredibly useful in determining sales goals! Understanding breakeven helps you set high enough prices to justify your company's continued operations without overcharging customers.
Find New Strategies for Increasing Your Profitability
Finally, calculating your Cost of Goods makes it easier to discover the most significant factors holding you back from achieving your profitability goals.
When you know the cost of everything that goes into creating a product or service, you can quickly identify the input expenses that are holding you back the most. Armed with that knowledge, you can begin brainstorming strategies to reduce your most significant input expenses and improve your profitability.
For example, let's say you run a clothing boutique. By tracking your cost of goods sold, you may discover that your shipping costs are making up an inordinate percentage of your input expenses. You could then begin focusing on lowering your shipping costs to increase your income.
Calculating Cost of Goods Sold
Bookkeepers and accountants typically use the following formula to calculate the Cost of Goods Sold over a specific period:
Beginning Inventory + Purchases - Ending Inventory = Cost of Goods Sold
For example, let's say you want to calculate the cost of goods sold at your clothing boutique for the quarter. You would start by determining the cost of your inventory at the beginning of the month, then add any additional inventory purchases during that month. After that, you would subtract the value of your stock at the end of the month. Your result would be the Cost of Goods Sold for that month.
You can use this same formula in various ways to generate actionable insights for your company. For example, you can look at the total Cost of Goods Sold for your business all at once. Or you can focus on specific items within your catalog of offerings.
You may also want to play with the time frames you look at. Doing this will help determine if your company's costs have been consistent over multiple months, quarters, or years. Or, you might find that you're less profitable during some periods you track, which could prompt insights that help you optimize your growth strategy.