What Is Cost of Goods Sold & Why It’s Important
Cost of Goods Sold (COGS) is a business number that’s overlooked and underestimated most of the time. Knowing all your business numbers is a good thing, but COGS should be in the top 5. Closely watching this number says a lot about your business.
- The actual cost of selling your product or service.
- How much was made from each sale?
- Are your prices not enough or too much?
- Is your business profitable or not?
Furthermore, cost of goods sold are reported on your tax filings. It’s a variable number; based on sales made during a specific period. If you made no sales, there are no COGS. After reading this blog post, you’ll know similarities and differences between the cost of goods sold and expenses, how to calculate it, and what makes up cost of products and/or services.
The Income Statement
Reports income and expenses (taxes and interest included) monthly, quarterly, or annually. Since a craft business has inventory, the extended income statement version is more suitable.
Short income statement:
total revenue – total expenses = net profit/loss
The extended version includes:
gross sales, cogs, gross profit, expenses, and profit/losses
There are other items but, let us keep it simple for now. Your income statement helps determine a few things. Can you increase business activity while keeping expenses the same? Are you able to hire employees? What expenses need to be cut or adjusted? Why is your cost of goods sold high? Can you offer discounts to customers? Does revenue needs to increase?
Similarities between the two
Both cost of goods sold and expenses are income statement accounts. They are a decrease in revenue and used to determine if the business made a profit or not. You can have good sales but lose money if both COGS and expenses are more than revenue. When net profits have high cogs and business expenses, you have a lower bottom line. The less profit there is, the less room for error there is as well.
How COGS and Expenses differ?
For starters, cost of goods are costs directly related to your product or service. Materials (raw, finished), supplies (packaging), and direct labor are included in cost of goods. Resale and dropship products do not include raw materials in cogs. Instead, you’d take the per-unit cost of the resale/drop shipped product.
Service-based businesses cost of goods includes labor time and outsourcing services used.
COGS Calculation for Product Based Business:
Beginning Inventory + Purchases – Ending Inventory = COGS
On the other hand, business expenses are mostly fixed costs. The cost of running a business is broken down into three main categories: general, selling, and administrative.
- Rent, utilities, insurance, and phone fall under general expenses.
- Marketing (website, web hosting, listings) and advertising are selling expenses.
- Administrative costs include payroll, taxes, and professional services.
As you can see
Both numbers are critical in your business. Gross profit/loss and net income/loss are affected by both numbers. Monthly monitoring of the cost of goods sold helps you set sales projections, figure out the break-even point, and what inventory to keep or discard.
High COGS might result from damaged/stolen inventory, price increases, or extensive labor. To reduce your cost of goods, consider ordering supplies in bulk, negotiating a lower rate with a vendor (if bulk ordering isn’t an option), or switch to a vendor that offers good quality items at a lower rate.
Most entrepreneurs focus on sales and the bottom line. To carefully evaluate the financial position of your business, you must know expenses and cost to sell products as well. It makes no sense to increase revenue when costs are doing the same.
What did you learn from today’s blog post? Please post comments in the section below.
To read Can a Craft Business be Profitable: Sales vs. Profit blog, click here.
Listen to Can a Craft Business be Profitable: Sales vs. Profit podcast, click here.