Calculating cost of goods sold for service businesses

Cost of goods sold (COGS) are those expenses a business incurs in the process of providing a product or service. Calculating cost of goods sold is completely different for service businesses than it is for manufacturers. Read on and learn about service business COGS. 


Calculating COGS for service businesses?

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Service businesses struggle to accurately calculate the cost of goods sold, but we make the process easy. If you’re tired of calculating COGS the hard way, just use our profitability modeling software with its built-in COGS calculator.

Profit Frog takes a revolutionary approach to calculating COGS and to FP&A in general. We focus on what helps service businesses stay ahead of the curve. Our profitability modeling tools not only track expenses and revenue— they allow you to predict future profits based on adjusting your different business drivers.

What are service businesses?

Service businesses are not selling products. Instead, they provide…services.  

Types of service businesses

Service companies come in many forms. Here are just a few types of service businesses.

  1. Law firm
  2. Plumbing repair company
  3. Human resources outsourcing company
  4. Motion picture theater
  5. Makeup artist
  6. Bank
  7. Computer services bureau
  8. IT system consultant
  9. Real estate agent
  10. Personal fitness trainer
  11. Consultant
  12. A digital marketing agency
  13. An accounting firm
  14. Business intelligence company
  15. Corporate financing consulting
  16. Customer success manager

What is cost of goods sold?

Understanding cost of goods sold (COGS) is crucial for running a profitable business. COGS is an important metric on company financial statements. It measures those costs associated with producing a good or delivering a service. Let’s look at how COGS applies differently to different business types. 

Cost of goods sold for service businesses

Since service businesses provide their customers with services rather than physical products, service companies have no “goods sold.” Many business owners will refer to this metric as cost of sales, cost of revenue, or cost of service. Regardless of the term used, it’s still COGS—in a slightly different form.

Service businesses should have the following costs included in COGS:

  • Sales commissions
  • Shipping costs
  • Direct labor

If you own a service business (for example a plumbing company), the cost of goods sold will include business expenses involved in providing the service: direct labor, tools, and parts used, and transportation costs.  

Cost of goods sold for manufacturers

For manufacturing companies, COGS, sometimes termed cost of sales, are direct costs associated with producing goods.

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. 

Manufacturing businesses should have these costs included in cost of goods sold:

  1. Product storage costs
  2. Product transport costs
  3. Tools and parts used in production
  4. Raw materials
  5. Factory labor costs

Key takeaways:

  • COGS includes all expenses directly related to the production of goods
  • Indirect costs such as overhead are excluded from cost of goods sold

Cost of goods sold for SaaS companies

SaaS businesses provide their customers with software instead of physical products. Calculating COGS is somewhat similar for SaaS as for other types of service businesses. Because SaaS companies have no “goods sold” some business owners will refer to this metric as cost of sales or cost of revenue. 

SaaS cost of goods sold includes:

  • Application hosting and monitoring costs
  • Data communication expenses 
  • Software license fees 
  • Website development and support costs
  • Subscription costs
  • Hosting costs

How to calculate service COGS?

Traditionally, calculating COGS is based on the inventory costing method.

Because service businesses don’t have inventory, most service businesses will find cost of goods sold calculations challenging with traditional inventory-based COGS formula. 

Profit Frog calculates COGS in real-time, rather than doing a retroactive inventory accounting after a calendar year (or month, or quarter) has closed. Our approach gives entrepreneurs more control and proactivity. For service companies, the Profit Frog approach is crucial.

Service business owners plug in all their costs, including COGS, into their dashboard, then see a current picture 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 OPEX, COGS, profit margins, and more into the future by manipulating variables and creating different scenarios. This type of business forecasting is called scenario planning, and it gives service companies the edge they need to navigate a volatile environment.

With our tools, business owners don’t need to stress about calculating costs, finding the correct cost of goods sold formula, or trying to calculate OPEX. Simply follow our prompts and see how fast and easy budgeting and forecasting can be. 

Traditional COGS formula for manufacturing businesses

The traditional COGS formula is of little use to service companies, but here it is for reference.

COGS = Beginning Inventory + Purchases During the Period – Ending Inventory

  • Beginning inventory: a business’s inventory at the beginning of an accounting period.
  • Purchases: costs incurred to produce a good or service during an accounting period.
  • Ending inventory: the inventory on hand at the end of an accounting period.

Let’s say your business had a beginning inventory value of $14,000. There are also $5,000 of costs (purchases), and you have $3,000 inventory remaining; that gives a COGS of $16,000 for the accounting period.

COGS = $14,000 + $5,000 – $3,000 = $16,000

Calculate service businesses’ cost of goods with this formula:

Cost of sales = beginning stock + purchases made during a period – closing stock

See what we mean? It’s inventory based and backward looking. You can do a lot better. 

What is the best COGS calculator?

Profit Frog helps you make sense of your financials and use them to develop a dynamic plan to greater profitability. Understanding COGS is crucial when planning for your service business. Our software includes a built-in COGs calculator that gives you real-time intel into your expenses. 

Profit Frog helps you compute COGS by having you plug in costs, such as the following.

  • Supplies needed for providing a service
  • Cost of storing products or materials
  • Wages for employees involved in the direct delivery of services

Our process gives you a clear understanding of what goes into providing your service. Ultimately, this will lead to having a better understanding of your business and where your profit centers lie.

By embracing dynamic planning, you will be able to stop guessing and break free from stagnant business plans that don’t work.

FAQ about COGS for service businesses

Is COGS included in operating expenses?

Cost of goods sold and operating expenses are separate categories of costs that companies incur. Operating expenses vs COGS values are recorded as separate items on the income statement. 

Operating expenses and COGS are mutually exclusive. If an expense is COGS it is not OPEX, and vice versa. 

Operating expenses include:

  1. Utilities
  2. Rent
  3. Legal costs
  4. Insurance costs
  5. Office materials and supplies
  6. Human resource costs
  7. Interest paid on debt
  8. Administrative expenses
  9. Any other indirect costs (expense not directly related to revenue generation)

Selling, general, and administrative expenses (SG&A) are included in OPEX; SG&A are fixed costs. Operational costs are linked to the administration and maintenance of a business on a daily basis. 

Is COGS an operating cost?

Cost of goods sold is a business expense, but is not an operating expense. OPEX are costs incurred in daily operations, regardless of sales volume—whereas COGS are associated with sales and fluctuate based on sales volume.

What are exclusions from COGS?

Direct expenses, also known as COGS, refer to any expenditures necessary for the production of goods or the delivery of services. 

Labor cost is not considered COGS unless it is directly involved in the production of goods or delivering a service. Marketing is not included in COGS, as it is not directly linked to the production of goods or the delivery of services. Instead, marketing is a part of OPEX. 

What are variable costs?

A company’s expenses consist of fixed and variable costs. 

Variable costs change in proportion to how much the company produces or sells. They fall when production decreases and rise when production increases. 

Variable costs are viewed as short-term costs because they can be adjusted quickly. For instance, if a business is having cash flow issues, it can take immediate steps to slow production or otherwise mitigate variable costs. 

Variable costs include direct labor costs, costs of raw materials, sales commissions, and some wages; cost of goods sold is mostly made up of variable costs

Is COGS an asset?

Cost of goods sold is not an asset. It is an expense. Expenses are the cost of running a business; they are one of five main accounts in accounting. 

  1. Assets
  2. Expenses
  3. Equity
  4. Revenue
  5. Liability 

COGS is an expense account on an income statement, making it a debit. Since COGS is a debit, not an asset, it is a business factor that should be minimized.

Credits are good and you want to have as many of them as possible.

  • Cash
  • Revenue
  • Equipment 
  • Real estate
  • Accounts receivable

Conversely, you want to minimize debits and liabilities. Even though some are necessary to the running of a business, you still want to keep them down.

  • COGS
  • Operating expenses
  • Accounts payable
  • Other debt

When you increase credits while keeping debits constant, your business’s profitability correspondingly increases. Or, if you decrease debits while keeping credits constant, your company’s profitability also increases. 

Increasing profitability is the main goal that Profit Frog aims to help service business owners achieve. It’s why we focus on profit modeling and dynamic planning. 

Get started with your free Profit Frog trial today.

Is the cost of goods sold an operating expense?

No, COGS and OPEX are different categories of business expenses. The difference between cost of goods sold and OPEX is that COGS directly relates to a specific product a business is selling—or a service a company is delivering. OPEX are costs incurred in day-to-day operations, regardless of whether any product is sold or not. 

OPEX and COGS combined make up the cost of doing business and are mutually exclusive. If an expense is COGS it is not OPEX, and vice versa. 

How to calculate gross profit?

Gross profit calculations measure business efficiency. By subtracting the cost of goods sold from revenue, you derive gross profit. 

How to calculate gross margin:

Gross Profit Margin = (Revenue – COGS) / Revenue x 100, 

Using this formula will show you the percentage of revenues your business keeps after COGS are deducted. This formula indicates how successful your business is at generating revenue while keeping expenses low. You can use a profit modeling tool to make calculations easier…and to ensure accuracy.

For example, say a seamstress made a dress for $50. Assuming the average cost for making a dress is $15, 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 ratio: 35/50 x 100 = 70%

The gross profit margin will vary across sectors and production, but it’s commonly used to measure the profitability of a particular product. It indicates how efficiently you are utilizing the resources in order to manufacture the product or deliver your service. 

Accounting methods for COGS

There are three traditional methods for calculating COGS. All are backward-looking and are based on inventory valuations. 

For small business owners, 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 your business’s inventory value.

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.

Get started today.

What is the average cost method?

The average cost method assigns the cost of your business’s inventory based on the average cost of goods available for sale during an accounting period. The average cost method is calculated by dividing the total COGS available for sale by the total units available for sale

Is having obsolete inventory bad?

Obsolete inventory, also known as excess inventory, is stock that a company doesn’t believe it will sell due to a lack of demand. Having obsolete inventory will negatively affect your business’s overall financial health. 

Does COGS include salaries?

Cost of goods sold does not include salaries, overhead costs, or other general and administrative expenses. 

Cost of revenue vs COGS: is there a difference?

No. Cost of revenue is just a different term for cost of goods sold. 

What are accounts receivable?

Accounts receivable (AR) is the balance of money due to a business for services delivered or used but awaiting customers payment. 

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, Profit Frog strips forecasting down to the thing that matters most: profitability—instead of pure sales revenue. Our financial modeling software allows you to assess your business’s financial health, 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. 

Get started with your free Profit Frog trial today!

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