Understanding the cost of goods sold is crucial for small business forecasting and budgeting. Profit Frog simplifies the understanding of the cost of goods sold. Our financial planning and analysis (FP&A) software helps small businesses track expenses, profit, and other key business drivers, and allows you to forecast into the future.
What Is COGS?
Cost of goods sold is an important metric on a financial statement. COGS, also termed cost of sales, measures the direct costs of 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, COGS appears on a company’s income statement.
Our COGS definition: all direct costs involved in manufacturing a product or delivering a service.
COGS is an essential element in calculating two crucial financial metrics;
- Gross profit
- Gross profit margin
Gross profit is calculated by subtracting COGS from revenue. You can calculate gross margin by dividing gross profit by total revenue, and multiplying the resultant number by 100.
What Is a Variable Cost?
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 cost, costs of raw materials, sales commissions, and some wages.
The Formula for Variable Costs
The total variable cost is the quantity of output multiplied by the variable cost per unit of output.
Total variable cost formula:
Total Variable Cost = Total sum of output x variable cost per unit of output
Variable costs per unit can vary across industries. In some cases, variable costs may need to be distributed across goods if they are being included in batches: for example, if 200 pounds of raw materials are purchased to manufacture 20,000 finished units.
The COGS Formula
Traditionally, COGS is derived by calculating inventory at the beginning and end of an accounting period. This is backward-looking and not especially useful to the business owner looking to proactively chart a profitable course through uncertainty.
That’s why Profit Frog developed a better way.
The traditional, inventory-based COGS formula:
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 remaining at the end of an accounting period.
With this traditional cost of goods formula, 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.
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, using a COGS calculator, or trying to calculate OPEX. Just follow our prompts and see how stress-free budgeting and forecasting can be.
We give you a clear view of your company’s sold COGS and show you where you can increase profitability.
Types of Variable Costs
Here are some common variable costs.
- Raw materials: they are direct goods processed and manufactured into the final product. A business should spend the same amount of raw materials for every good produced, assuming there are no significant differences in manufacturing them.
- Direct labor: a business won’t incur some types of labor if it doesn’t produce more output. Some positions can be salaried; some individuals will receive the same amount of compensation. For those who are tied to an hourly job, putting in direct labor will result in a higher paycheck.
- Commissions: in most cases, commissions are a percentage of sales that is awarded to a business as additional compensation. If there are no sales, there is no commission.
- Utilities: as your business strives to produce more goods, it is likely that there will be additional power or energy usage, resulting in increased variable utility costs.
- Shipping: the cost of shipping or packaging a product will vary depending on the quantity of goods shipped.
Examples of variable costs include cost of goods sold, commission, certain utilities, packaging, and raw materials.
Is COGS Variable or Fixed Cost?
While it can include both fixed and variable expenses, 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 cost of goods sold 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).
Frequently Asked Questions About COGS
What is the cost of goods sold classified as?
Cost of goods sold is an expense in accounting and it can be found on a financial report called an income statement.
Using Profit Frog’s financial modeling software will help you navigate uncertainty and have correct summaries. It will help you understand how modeling your financial profitability will improve your business performance.
What is COGS in accounting?
Cost of sales, also referred to as cost of goods sold, is an estimate of direct costs incurred in the production of goods sold by a business within a certain time frame. Cost accounting methods will differ depending on the industry, but COGS measures direct costs such as direct labor and materials; it excludes indirect costs like distribution expenses and sales.
For instance, the cost of goods sold by a pastry shop would be the cost of labor used to make the desserts and ingredients. Only costs directly linked to producing pastries are included in the COGS. Costs that aren’t directly involved in the production of goods, such as distribution costs, utilities, and rent, are not included in COGS.
A key part of calculating COGS is your inventory. The inventory balance consists of merchandise and products waiting to be sold, cost of raw materials, and work-in-process goods.
The merchandise that didn’t get sold in the previous year becomes the beginning inventory for next year. If the company buys or makes additional products, these will be added to the beginning inventory.
What is included in the cost of goods sold?
All costs associated with manufacturing a product or delivering a service are all expenses included in COGS. For instance, if your business sells a physical product, COGS can include fixed and variable costs, transportation costs, the value of your inventory, direct material costs, and other direct expenses.
Businesses that sell and manufacture products should have these fixed and variable costs incorporated in COGS:
- Raw materials
- Storage cost
- Transport cost
- Tools and parts used during the production
- Factory labor
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, it is a part of OPEX.
Even though accounts receivable and inventory are accounts that an owner reports on the balance sheet, not all 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 company sold during an accounting period.
Is COGS included in operating expenses?
Cost of goods sold and operating expenses are completely separate categories of costs that companies incur. COGS and OPEX 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:
- Legal costs
- Insurance costs
- Office supplies
- Human resource costs
- Interest paid on debt
- Administrative expenses
- Any other indirect cost (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.
Operating expenses vs COGS calculations are difficult and confusing for most small business owners. Profit Frog also offers profit modeling software that guides you to optimize your net income (profit).
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.
COGS is an expense account on an income statement, making it a debit. Because COGS is a debit, not an asset, it is a business factor that should be minimized.
Assets are things like accounts receivable, real estate, equipment, cash on hand, and other things that have value.
To calculate the cost of goods sold, just divide COGS by total revenue and then times the resultant number by 100.
The formula for calculating COGS percentage: (COGS / Total revenue) X 100
COGS percentage example
A shoemaker has spent $900 on inventory items during a fiscal quarter and had $300 worth of inventory on hand at the end of the quarter. He sold 100 shoes for $50 per pair during the quarter.
- First, calculate COGS: 1000 + 900 – 300 = 1600
- Calculate total sales: 100 x 50 = 5,000
- Calculate the COGS percentage: 1600 / 5,000 = 0.32
- Times by 100: 0.32 x 100 = 32
The shoemaker has a COGS percentage of 32%.
COGS vs operating expenses in SaaS
Correct coding of SaaS COGS vs operating expenses is crucial for numerous reasons. Without correct expense coding between COGS and OPEX, have trouble calculating gross profit accurately.
What is the difference between COGS and SG&A?
Selling, general and administrative expenses include all costs that are non-production. SG&A is often used as a synonym for OPEX, yet they are sometimes shown as separate line items on income statements.
Selling, general, and administrative expenses are usually associated with the overall overhead as they can’t be directly traced to production.
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. 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. For those small businesses struggling to grasp the calculation of cost of goods sold, Profit Frog simplifies the process.