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 financial planning and analysis software helps small businesses track expenses, profit, and other key business drivers, and allows you to forecast into the future.
What are Fixed Costs?
Fixed costs, sometimes termed overhead costs, are costs that don’t change based on production levels. Fixed costs are commonly related to recurring expenses such as utilities, rent, insurance or any expense that a business has to pay to remain operational.
In most cases, fixed costs are indirect, as they are not directly related to production or delivering services.
Fixed Costs are Mostly OPEX
Operating expenses are those costs necessary to sustain day-to-day operations, but which are not directly related to producing a good or delivering a service. The majority of fixed costs are OPEX.
Most common OPEX fixed costs:
- Utility costs
- Insurance costs
- Rent and lease costs
- Administrative expenses
Which Fixed Costs Qualify as COGS?
Accountants disagree over COGS including any fixed costs at all. Some argue that any fixed costs belong in OPEX, while others allow a few fixed costs to qualify as cost of goods sold.
Fixed costs that are sometimes included in COGS are:
- Equipment depreciation costs
- Supervisor salaries
- Electrical bills
- Website hosting bills
- Licenses and permits
- Vehicle licensing
How to Calculate Fixed Costs?
The traditional fixed cost formula is backwards-looking, deriving fixed costs from variable costs. This means waiting until an accounting period (whether a month, a quarter, or a year) is closed to have visibility into fixed and variable costs. We prefer a real-time approach. But, here’s the traditional fixed-costs formula.
Backward-Looking Fixed Cost Calculations
Fixed costs = (total costs – variable costs)
Let’s say that you own a burger place and you have $5,000 in total monthly costs. You sold 1,500 burgers one month and each burger costs $2 to make. Your COGS (variable costs) will be $2 X $1,500 = $3,000. Your fixed costs will be the rest of the total, or $2,000.
$5,000 total costs – ($2 x 1,500 burgers) = $2,000 fixed costs
Real-Time Cost Calculations
By deferring fixed cost 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 direct and indirect costs. Hence, they don’t know where to focus their cost-reduction efforts.
Instead of struggling with backwards-looking calculating methods, Profit Frog offers real-time visibility into a company’s finances.
Business owners plug in expenditures regularly, and our software helps code them correctly. With Profit Frog, you have up-to-date visibility into fixed vs variable costs, COGS, OPEX, profitability, and all the other metrics that matter.
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.
COGS for Manufacturing Businesses
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 Service Businesses
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.
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 SaaS COGS 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.
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
There’s the traditional, backwards-looking way of calculating COGS. Then there’s the real-time, Profit Frog way.
Traditional COGS Formula
The traditional, inventory-based cost of goods sold formula retrospectively calculates COGS after an accounting period has closed. This doesn’t give 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.
Is COGS Fixed Or Variable Costs?
While it can include both fixed and variable costs, COGS is mostly variable costs. However, some accountants consider the cost of goods sold to be exclusively variable expenses, putting any fixed expenses under OPEX.
Most common fixed costs included in the COGS are equipment depreciation costs and salaries for personnel responsible for product quality.
Together, variable and fixed costs make up the total expenses of running a business.
An administrative cost is commonly mistaken for a variable cost; it is a fixed cost, and a part of operating expenses (OPEX).
What are variable costs?
Variable costs are corporate expenses that change in proportion to how much your business sells or produces. Depending on your company’s sales value or production, variable costs will increase or decrease—they fall as the production decreases and rise as production increases.
The majority of COGS are variable costs as they include direct labor costs and material inputs.
Variable costs can include:
- Raw materials: these are purchased and used for creating the final product.
- Direct labor: workforce inputs that contribute directly to producing a product or delivering a service.
- Commissions: a percentage of sales that is awarded to salespeople as performance-based compensation. If there are no sales, there will be no commission expenses; higher sales bring higher commission payouts.
- Utilities: a business may consume more electricity, water, and other resources if production increases.
- Shipping: transportation and shipping costs are usually fairly constant on a per-product basis, but total shipping expenses increase with the quantity of product shipped. Thus, increased output brings increased transportation cost.
Calculating total variable costs is simple. The quantity of output is multiplied by the variable cost per unit of output.
Total Variable Cost = Total Quantity of Output X Variable Cost Per Unit of Output
You can then forecast future scenarios by manipulating all of your business variable costs. This is known as scenario planning, and it helps you navigate uncertainty and guide your company toward success.
Embracing dynamic planning will allow you to stop guessing and break free from stagnant business plans that don’t work.
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. Our guide on COGS vs OPEX might help clarify the differences further.
What costs are included in COGS?
Cost of goods sold includes all costs of developing (manufacturing) a product or delivering a service. For instance, if your business makes and sells a physical product, COGS will include transportation costs, factory labor costs, raw materials purchases, and other direct expenses.
Businesses that sell and manufacture products should have these variable costs as part of their COGS:
- Cost of raw materials
- Storage costs
- Transport costs
- Tools and parts used during the production
- Direct labor
What is not included in COGS?
Direct expenses, also known as COGS, refer to any expenditures necessary for the production of goods or the delivery of services. Everything else is excluded from COGS
Not included in COGS: managerial expenses, advertising, utility expenses, lease payments, office supplies, and other overhead.
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
Is COGS an asset?
COGS 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.
Cost of goods sold is an expense account on an income statement, making it a debit. Because the cost of goods sold is a debit, not an asset, it is a business factor that should be minimized.
Even though accounts receivable and inventory are assets on the balance sheet, only some expenses on the income statements will involve these items. The cost of goods sold on your income statement will report the cost of the inventory your small business sold during an accounting period.
How to calculate gross profit?
Gross profit calculations measure business efficiency. By subtracting the cost of goods sold from revenue, you derive the gross profit number.
How to calculate the 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.
By using our profit modeling software, you will simplify budgeting and track your business’s profit. Having a clear picture of what COGS and gross profit are and how they work will reduce any uncertainty and fears.
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.
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.