Cost of goods sold is indeed a business expense. So are operating expenses. Do you know the difference between the two? Many business owners get these two metrics confused.
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If you don’t know how to clarify a particular cost, you might end up double-counting an expense, which would create inaccurate financial statements for your business. You don’t want that: it could skew your profit modeling and otherwise wreak havoc on your business plans.
What is cost of goods sold?
Costs of goods sold (COGS) is the “direct costs of producing the goods sold by a company” (Investopedia). COGS includes any costs in labor or materials used to create a product or deliver a service. It does not include other, more indirect expenses, such as utilities, distribution costs, marketing costs, sales force costs, and other, more predictable line items. COGS is how much it directly costs you to produce your product and get it to the customer.
Operating expenses vs COGS
To conflate COGS with expenses is to conflate a subcategory with its parent category. COGS is an expense, making up a portion of total expenses. The other portion of expenses, operating expenses, are the non-COGS expenses.
COGS
COGS is often called “cost of sales” and is directly linked to the specific product you are selling. It’s often a variable cost (but not exclusively so) that fluctuates based on sales volume (how many products you are selling). Expenses included in COGs:
Raw materials needed to make a product
Manufacturing expenses
Transportation expenses to get the product to a retail location—or to the customer directly
Direct labor costs: any labor cost involved in the making or transporting of the product
Operating expenses
Operating expenses (commonly abbreviated OPEX), in contrast, are any business expense your company incurs in its normal course of operations—whether it makes sales or not. Whereas COGS are directly associated with goods sold, operating expenses are associated with the company’s operations and tend to exist independently of sales and sales volume. Operating expenses are all of the non-COGS expenses a business incurs to keep the lights on and stay in business. Operating expenses cannot include the direct cost of producing a good since that cost is measured in our cost of goods sold calculation. The following are some examples of a company’s operating expenses:
Any administrative expense
The cost of accounting software
HR and payroll costs
Lease, rent, or mortgage payments on commercial real estate
Professional courses to upskill staff
Data management or business intelligence tools
Office supplies
Marketing campaigns
Utilities
Supply chain costs not directly related to producing your product
To help you get a handle on operating expenses vs COGS, here are some hypothetical examples.
Coffee shop
COGS: The paper cups needed to serve hot coffee to customers. OPEX: The monthly lease payment to operate the store.
Software company
COGS: Website development and hosting cost. OPEX: Research & development.
Gas station
COGS: Transportation of fuel. OPEX: Electricity costs for store and office. Sign up for free No credit card required
Is COGS a fixed or variable cost?
COGS is mostly variable costs, since it consists of expenses directly related to revenue production. In high-revenue months, COGS will be higher, and similarly it will be lower in lean months. However, COGS may include some fixed costs for certain types of businesses.
COGS vs SG&A
As with operating expenses, many folks confuse COGS with selling, general, & administrative (SG&A) expenses. However, COGS and SG&A are mutually exclusive categories of expenses, and SG&A is commonly used as a synonym for operating expenses. Some accountants consider OPEX and SG&A to be the same, while others draw subtle distinctions between the two.
What is included in COGS?
COGS includes all direct costs of generating revenue. For a manufacturing business, these would include manufacturing labor, raw materials, certain transportation costs, and other costs directly related to the manufacturing process. For a service company, COGS would include direct costs related to providing the service. COGS does not include marketing, sales, or administrative expenses. Sign up for free No credit card required
When COGS gets confusing
Depending on the industry, traditional operating expenses could be a COGS instead. For example, a service company’s wages to fulfillment personnel would be considered COGS since they are directly related to delivering the product (in this case, the company’s service is the product)
How Profit Frog helps clarify COGS and OPEX
When you log on to Profit Frog, our software allows you to choose from existing industry templates. For purposes of this article, we’ll choose the “Marketing Agency” template. You’ll see a net income chart. Click the “Enter your data” button. Our pre-built profit plan populates shows a hypothetical agency’s numbers. They are organized into three categories:
Expenses
Products
Customers.
We’ll focus on expenses and products. Under expenses, you’ll see examples of typical costs an agency is responsible for. Notice that these are operating expenses. Since we want to be careful not to duplicate expenses, we do not include direct costs of delivering our product or service (i.e., our COGS). We’ve underlined typical agency expenses, such as the internet and electricity bill, the lease, and wages for the account manager. Next, we’ll open our product category. Since we want to be careful not to duplicate expenses, we do not include direct costs of delivering our product or service (i.e., our COGS). We’ve underlined typical agency expenses, such as the internet and electricity bill, the lease, and wages for the account manager. Next, we’ll open our product category. This hypothetical marketing agency is focused on internet marketing. In Image 4, you can see costs like website building, SEO implementation, and content development. These are the agency’s COGS. When we click “edit” per product, we can see where the COGS is inputted. But how do you come up with the correct number for COGS? You use Profit Frog’s COGS Calculator, of course. Click on the “COGS Calculator” button to get started. In the window for calculating COGS, you enter the various costs for materials, labor, and other direct costs.
Cost of goods sold formula
There’s a conventional formula for calculating cost of goods sold, but it’s backward-looking and not particularly useful for a small business owner who’s trying to navigate a challenging business landscape. That’s why we created our COGS calculator. Ultimately, our calculator and the traditional COGS formula will produce the same output for manufacturing companies. When calculating COGS for service businesses, use the Profit Frog way; the inventory-based COGS formulas simply won’t apply.
The traditional cost of goods sold formula
The traditional COGS formula for a company selling a product is as follows:
Calculating COGS:
COGS = (beginning inventory + purchases and other costs) – ending inventory
This COGs formula, while accurate from an accounting standpoint, is not the most useful for owners of small businesses. It would have you calculate the cost of goods sold for an accounting period (say, a fiscal year):
Take your inventory value at the beginning of the year
Add to it any purchases and applicable expenses (we’ll talk about those in a minute)
Subtract the value of your inventory at the end of the fiscal year
The resultant value is your COGS for the year. It’s a lagging indicator–you are looking backward after the close of the year–and tends to be a rather academic exercise. Good for accountants, not so useful for a business owner trying to make decisions. We prefer to approach COGS in a different, more actionable way.
Itemized COGS calculator for small businesses
Profit Frog makes COGS immediate and actionable. We take an “itemized COGS” approach that gets you intimately familiar with the direct costs of producing your goods or services. We help you compute COGS and track the most important COGS metrics by having you input the costs of the following, item by item:
Your direct materials
Direct labor costs
Shipping costs
Waste
…and other direct costs
This process forges a deep understanding of exactly what goes into producing each product or service—which ultimately leads to a much better understanding of your business and where your profit centers lie. Where the traditional COGS formula is nebulous and academic, our COGS calculator allows you to dynamically model your various costs and create scenario planning forecasts based on their fluctuations.
Profit Frog makes COGs calculations easy
Profit Frog allows you to collect and analyze data for cases like evaluating current or future products. Understanding COGS and operating expenses is critical when planning for your business. Our COGS calculator gives you a clear picture of your expenses so you can build the company you want. Profit Frog is a financial forecasting software designed for small businesses that allows them to easily plan for different scenarios and model profitability based on those scenarios. If you’ve considered implementing financial modeling and forecasting in your small business, give Profit Frog a try today! Click here to try Profit Frog for free. This article shows readers how they could use Profit Frog for their business. This is not financial advice, and readers should consult a financial professional when making decisions. Sign up for free No credit card required
