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 COGSTo 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.
COGSCOGS 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 expensesOperating 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
- Supply chain costs not directly related to producing your product
Examples of OPEX vs COGSTo help you get a handle on operating expenses vs COGS, here are some hypothetical examples.
Coffee shopCOGS: The paper cups needed to serve hot coffee to customers. OPEX: The monthly lease payment to operate the store.
Software companyCOGS: Website development and hosting cost. OPEX: Research & development.
Gas stationCOGS: 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&AAs 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 confusingDepending 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 OPEXWhen 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:
Cost of goods sold formulaThere’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 formulaThe traditional COGS formula for a company selling a product is as follows:
COGS = (beginning inventory + purchases and other costs) – ending inventoryThis 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
Itemized COGS calculator for small businessesProfit 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
- …and other direct costs