Understanding Cost of Goods Sold (COGS)

The Account on the Income Statement called Cost of Goods Sold (COGS) can be confusing to non-accountants. In this article, we’ll attempt to demystify it and explain how it works.

COGS Definition & Overview

Cost of Goods Sold (COGS) are expenditures in the course of business directly related to the production of revenue. COGS are also referred to as the “Cost of Revenue” or “Cost of Sales.” In a nutshell, COGS tracks how much a business is spending to generate their top line sales. COGS differ from overhead expenses in their direct connection to the production of revenue, while overhead expenses are related to the operation of the business as a whole.

All expenditures essential to producing top line revenue are considered COGS. For example, a business reselling widgets would count the cost of the widgets as a COGS, whereas a business manufacturing widgets would count raw materials, supplies and labor that go into the widget manufacturing process.

The lower COGS, the better, as it indicates a high profit margin on sales or services. While COGS should certainly be a focus for optimizing financial health, some business models naturally lend themselves to higher margins (eg. Plant health care or grading) or lower margins (eg. general contractors).

The Benefits of Using COGS

Business that use COGS are able to achieve better visibility into their profit margins, allowing them to identify opportunities to increase profitability.

However, many businesses do not separate out COGS at all. This means that their overhead expenses are comingled with COGS. For example, let’s say that a business is putting material costs in COGS but is not splitting out labor that is tied directly to revenue production. This would mean that sales labor and supervisors are in one Payroll expense line item, along with administrative staff. Doing this would overstate margin and overstate overhead expenses.

COGS tracks how much a business is spending to generate their top line sales

Types of COGS

There are two types of COGS: direct and indirect. Direct COGS relate to the actual job or customer project. This could include labor, subcontractor work, and materials. Any costs coded directly to a job should be included in the Direct COGS Account.

Indirect COGS still relate to the production of revenue, but cannot be tied to a specific customer, job or project (at least not easily). For example, fuel, is an indirect cost of performing a job or service; it would be really difficult to allocate each gallon of fuel to a specific project or job.

COGS Types Examples: General Contractor

COGS in the Chart of Accounts

A business’ Income State (Profit & Loss) starts with Revenue at the top. COGS is listed next and is subtracted from Revenue to arrive at Gross Profit. Operating Expenses are then subtracted from Gross Profit to arrive at Net Income. Typically, Accounts would be numbered 4xxx for Revenue Accounts, 5xxx for COGS and 6xxx for Expenses, but there is no rule here.

While COGS is an important metric for financial health, it’s important not evaluate COGS alone. Gross Profit is the most important metric, but a business must be able to drill-down and understand the underlying metrics. For example, analysis of the individual COGS line items against planned budget should be evaluated to understand which are at, above or below target.

Let’s say that labor is constantly over target for a business. Are we working too slow? Are we underbidding jobs? Are crews milking the clock? Is overtime (time and half) the culprit? Once a business determines why this line item is running over budget, they can make changes to increase profitabilty.

COGS & Margin

A higher cost of goods sold will mean a lower margin. If a business isn’t hitting its target Profit ($) or Margin (%) it’s very hard to cut operating expenses to make up the difference. Usually that difference is lost profit. Let’s say a business is 3.3 percentage points below target. That small % might sound trivial, but it could equate to 100s of thousands of dollars in additional cash and profit if they were hitting it.

COGS vs. Assets vs. Expenses

When purchasing an inventory item for sales, it’s considered an asset (not an expense yet). When selling the inventory item, the asset is reduced and the COGS Account is increased, moving the item from an asset to the COGS section. Once sold, it’s no longer an asset and the cost of the item sold reduces profit and is deducted front the revenue earned to generate Gross Profit.

We hope the below definitions help to clarify.

• Asset – Property owned by a person or company regarded as having value and available to meet debts, commitments or legacies
• Operating Expense – Asset consumed in the ordinary course of business
• COGS – Asset consumed in the course of business related to the production of revenue

COGS by Industry

Wholesale & Retail:

In the case of wholesale and retail businesses, the cost of goods sold is the amount that was paid for the inventory items to be sold, plus any shipping costs or labor for delivery. For example, a restaurant record food costs, labor costs and consumables (paper, plastic) as COGS. In this industry where margins are often tight, it is important to track COGS by location as well to understand which locations might be the most or least profitable, diagnose and fix issues.

Manufacturing:

In the case of a manufacturer, Inventory (and once sold, COGS) includes the cost of raw materials, labor to produce the item, and sometimes additional allocations of other related costs. Manufacturing businesses must also calculate yield, something most other businesses don’t. For example, buying a sheet of steel might cost $130 dollars and make 3 widgets. Waste is factored in for the remaining portion of the steel. Most manufacturers do the $130/3 match and count any scrap value as “free” and don’t factor it into the cost.

Manufacturers also use a lot more inventory Accounts than a service or construction businesses. For example, they may have Accounts for raw material inventory, work in process inventory and finished good inventory. When they sell 100 widgets, they take the cost of production and move it from the balance sheet to the Income Statement as COGS.

Construction:

Construction businesses may have many COGS accounts, ranging from Direct Labor, Materials, Subcontractor, and Indirect COGS (things like fuel, job supplies, equipment maintenance, etc).

A unique challenge for construction businesses is aligning the timing of recording Revenue and COGS. For example, let’s say a construction business is using COGS but 75% of the Revenue is on the balance sheet as a deposit liability. They will finish the job and the Revenue will be recognized in the following month. This would mean all of the costs would be recorded in months 1 and 2, but the Revenue would be recorded in month 3. Both must hit the PL at the same time or the monthly Gross Profit $ and Margin % will be very difficult to track.

Professional Services:

Many service businesses do not track Cost of Goods Sold which we at Lucrum feel is a mistake. Taking this shortcut eliminates the opportunity to track profitability by job or customer. Additionally, labor is a big consideration for Services businesses using COGS. Sales or other production labor can be separated from the overhead of Administrative labor costs.

Tax Implications of COGS

Lower COGS means higher profitability, and that you’ll likely pay more taxes. But the company made more money and we have a more valuable business! If looking to sell the business, those with higher margins will sell for more than their competitors. It’s also likely to have better cash flow with a lower COGS, which is KING.

While this COGS primer is for a basic understanding, COGS implementation will vary from business to business. At Lucrum, we have experience across industries and can any any questions you have about this or any other aspect of accounting. Don’t hesitate to contact us if you need help implementing and optimizing your COGS.