Understanding what the cost of goods sold includes and how to calculate it is a crucial part of budgeting, planning, and financial forecasting for small businesses.
Profit Frog simplifies COGS for small businesses. Our FP&A software helps small businesses track expenses, profit, and other key business drivers, and allows you to forecast into the future.
What are Business Metrics?
Business metrics are measures used to track your company’s performance levels. The most effective way of using business metrics to improve your business’s performance levels is by tracking and managing them.
What is Cost of Goods Sold?
Cost of goods sold measures those costs associated with producing a good or delivering a service.
Generally accepted accounting principles (GAAP) COGS definition: the overall cost of manufacturing the items sold during a selected period. Along with revenue, cost of goods sold will appear on income statements.
Profit Frog’s COGS definition: all direct costs involved in manufacturing a product or delivering a service.
Cost of goods sold is a key component when calculating three crucial business metrics:
- Gross profit
- Gross profit margin
- Net profit margin
COGS for Manufacturing Companies
COGS, sometimes referred to as cost of sales, measures the direct costs of producing goods for a manufacturer.
Cost of goods sold includes all costs associated with manufacturing. For example, if a company is selling a physical product, the cost of goods sold will include transportation costs, direct material costs, and any other direct expenses.
The COGS figure consists mostly of variable costs. Some companies consider the cost of goods to include all of their variable expenses, and put all fixed expenses under overhead costs (operating expenses).
COGS for SaaS Companies
Since SaaS businesses provide their customers with software instead of manufacturing goods, calculating COGS is quite different. Because SaaS companies have no “goods sold” most business owners will refer to this metric as cost of sales or cost of revenue.
Understanding COGS for SaaS businesses is important for correct accounting and modeling. Our SaaS business forecasting software includes a handy cost of goods sold calculator to make COGS—and all other aspects of budgeting and forecasting—much easier.
COGS for Service Companies
If you own a service business (for example a locksmith company), COGS will include business expenses involved in providing the service: direct labor, tools, and parts used, and transportation costs.
What is Included in COGS?
Cost of goods sold includes all costs associated with manufacturing or developing a product such as:
- Purchase returns and allowances
- Trade or cash discounts
- Factory labor
- Production costs
- Direct labor
- Raw materials
- Inventory acquisition expenses
- Parts used in production
- Storage costs
Which COGS Metrics Matter Most?
When it comes to tracking your businesses COGS metrics, the numbers that matter the most are:
- Production costs
- Direct labor
- Raw materials
- Inventory expenses
Tracking these COGS metrics will help you model profitability under a variety of hypotheticals and effectively steer your company to greater and greater profits—even in uncertain economic conditions.
Production costs refer to direct costs a company faces when manufacturing products or providing services.
Production costs include a variety of expenses such as manufacturing supplies and factory overhead.
Keeping track of production costs is essential when estimating net profit or net loss for your business.
Direct labor costs are attached to employees who are directly responsible for producing goods or services. These include assembly line workers, service technicians, and other workers directly involved in manufacturing or service delivery. Having a clear picture of direct labor costs is crucial for accurate coding of COGS.
Raw materials are your business’s stockpile of all the substances that will be used to manufacture your products.
Tracking raw materials is crucial for inventory management. When business owners fail to track raw materials properly, they are risking stockouts. Tracking raw materials is especially important for businesses that work with slow-to-ship materials.
Tracking inventory expenses refers to monitoring all the ivory of your business. In most cases, inventory will contain raw materials, unfinished products as well as items that are ready to be sold.
Inventory tracking monitors:
- Updated stock levels
- Stock locations
- Inventory accuracy
- Carrying costs
- Inventory valuation and turnover
- Recorder levels
Tracking inventory expenses plays a beneficial role in having better stock visibility, inventory forecasting, avoiding shortages, and faster error detection.
Should Your Business Have Higher or Lower COGS?
COGS are unavoidable, but you always want them as low as you can get them. Lower COGS equates to higher profitability, assuming constant revenue. Higher COGS will get you a bigger tax deduction, but your net income will be lower. Since your goal as a business owner is to make as much profit as possible, you always want your expenses (including COGS) as low as possible while having revenue as high as possible.
A good average COGS number is around 31%.
Lucky for you, our profitability modeling tools will help you easily pinpoint COGS and profit—and chart a course to higher profit and relatively lower COGS.
Why is it Important to Track COGS?
Discovering the COGS associated with your business allows you to deduct those costs from the products you sell, whether you manufacture them or re-sell them.
Even more importantly, accurate coding of COGS allows you to identify your profit and cost centers so you know which levers to pull to increase profitability.
By having a clear handle on COGS, operating expenses, and revenue, you can utilize scenario planning to map a path to maximum profits.
There’s the traditional, backwards-looking way of calculating COGS. Then there’s the real-time, Profit Frog way.
Traditional COGS Formula
The traditional COGS formula retrospectively calculates the cost of goods sold after an accounting period has closed. This doesn’t allow much actionable insight to the entrepreneur trying to make real-time decisions.
COGS = Beginning Inventory + Purchases during the period – Ending Inventory
- Beginning inventory: a business’s inventory at the beginning of an accounting period.
- Purchases: the cost incurred to produce a good or service during an accounting period.
- Ending inventory: the inventory remaining at the end of an accounting period.
All inventory that is sold will be shown as sales. The items that didn’t get sold in the previous year become part of the beginning inventory for the upcoming year. If the business makes or purchases additional products, they will be added to the inventory.
There’s a better way to track COGS (and OPEX too, for that matter).
Calculating COGS with Profit Frog
Profit Frog takes a real-time approach to COGS. Business owners plug in all their costs, including COGS, into their dashboard and see a current snapshot of their business’s health.
No waiting until the end of an accounting period: they have up-to-the-moment visibility into the real drivers of their business. Then, they can forecast COGS, OPEX, profit margins, and more into the future by manipulating variables and creating different scenarios. This is known as scenario planning and it helps our customers stay ahead of the curve.
With Profit Frog, business owners don’t need to stress about calculating costs. Just follow our prompts and see how stress-free budgeting and forecasting can be.
We give you a clear view of what’s going on in your business and where you can increase profitability.
Frequently Asked Questions About COGS
Where is COGS used?
Along with revenue, COGS also shows up on income statements.
Cost of goods sold is a key component when calculating gross profit and gross margin. Gross profit is calculated by subtracting COGS from revenue.
COGS is also used in net profit calculations. Net profit is your business’s sales minus all expenses (COGS and OPEX). In our opinion, it’s the single most important metric for you to focus on. After all, it’s not so much about how much money passes through your company; it’s about how much you keep.
Net profit formula:
Net Profit = Gross profit – total expenses
Understanding the cost of goods sold is crucial to running a successful business, and we help you track COGS proactively so you can be in the driver’s seat of your business. Our software has a built-in COGS calculator and makes budgeting and forecasting easy.
How do you calculate gross profit margin?
Gross profit margin is the ratio of gross profit to revenue, expressed as a percentage. Here is the gross profit margin formula: Gross Profit Margin = (Revenue – COGS) / Revenue x 100.
For example, say a seamstress made a dress for $50. Assuming the dress costs $15 to make, the seamstress has a gross profit of $35. In this example, the seamstress would have a gross profit margin of 70%.
- Total product revenue: $50
- Total cost of production: $15
- Gross profit: 50-15 = $35
- Gross profit margin: 35/50 x 100 = 70%
A company’s gross profit margin indicates how successful it is at generating revenue while keeping COGS low.
Our profit modeling software shows your gross profit margin, and every other type of profitability calculation you could ever need.
Is COGS OPEX?
COGS and operating expenses are two different categories of costs that businesses incur. COGS vs OPEX values are recorded as separate items on the income statement.
Operating expenses (OPEX) and COGS are mutually exclusive. If an expense is OPEX it is not COGS, and vice versa.
Operating expenses should include:
- Legal costs
- Insurance costs
- Office supplies
- Administrative expenses
- Interest paid on debt
- Human resource costs
- Any other indirect cost (expense not directly related to revenue generation)
Are cost of goods sold the same as the cost of doing business?
No, COGS and the cost of doing business are not the same. Cost of doing business includes all costs a company incurs, both COGS and OPEX.
What is the accounting method for COGS?
There are three traditional methods for calculating COGS. All are backward-looking and are based on inventory valuations.
For small businesses, we recommend none of these three accounting methods. Instead, we favor a real-time COGS tracking model.
The three traditional COGS accounting methods are the FIFO method, the LIFO method, and the WAC method. All three are formulas to value your inventory—and to derive COGS from inventory values.
Actionable expense tracking
Instead of the above inventory-based accounting methods, Profit Frog offers real-time visibility into a company’s COGS.
By deferring COGS calculations until after the books are closed on an accounting period, many business owners make a crucial, sometimes fatal mistake: they don’t have a real grasp on their cost of goods sold. Hence, they don’t know where to focus their cost reduction efforts.
In addition to modeling costs (COGS and OPEX), Profit Frog allows small businesses to model growth, new market opportunities, and other variables.
Plus, calculating the cost of goods sold is much easier when you use Profit Frog.
What are the limitations of COGS?
Inventory-based COGS accounting systems are traditionally used in larger companies. Usually motivated by a desire to impress investors (or potential investors), accountants can manipulate COGS via any of the following:
- Not writing off obsolete inventory
- Fudging the amount of inventory at the end of an accounting period
- Overstating discounts
- Overstating returns to suppliers
- Valuing end-of-period inventory at more than the actual value
Because the value of inventory can be artificially inflated, the cost of goods sold can be under-reported, which can show artificially-inflated net income.
Profit Frog customers typically aren’t subject to the same COGS limitations for the following reasons.
- Our average customer is a bootstrapped Main Street business, not a VC-funded startup
- We don’t use backwards-looking inventory valuation systems for calculating COGS; instead, we use a real-time approach that helps you stay ahead of the curve
About Profit Frog
Profit Frog is the leading budgeting and forecasting software specifically designed to eliminate complexity for small businesses. Where other FP&A software solutions focus on complex forecasting of cash flows and other factors suitable to private equity forecasting, Profit Frog strips small business financial modeling down to the thing that matters most: profitability. Our profitability modeling tools allow you to assess the health of your business quickly, and look into the future to understand how all of your variables will affect future profitability as you adjust them. Armed with this knowledge, you can chart a path to maximum profit. Also, for small businesses struggling to grasp the calculation of cost of goods sold, Profit Frog simplifies the process.