WHY COST OF GOODS SOLD (COGS) MATTERS
As a business owner, you are almost certainly familiar with the term “Cost of Good Sold” or “COGS.” In fact, it is often the second line on your income statement, just below the big one – “Revenue.” But COGS is more than just a number pasted into the accounting spreadsheet. It can give you clues about the health of your business, point to steps you might take to improve your profits, help recognize tax opportunities or risks, and look for growth opportunities. Let’s look at some of the intricacies of your Cost of Goods Sold.
HOW COGS IS CALCULATED
The calculation of COGS is straightforward:
COGS = (Inventory at beginning of period) + (Inventory added during period – including related labor, material, & manufacturing costs) – (Inventory at end of period)
As you can see, your Cost of Goods Sold is inextricably linked to your inventory, so it is important that you implement an effective and accurate inventory tracking system, as well as carefully choose your method of inventory accounting, such as First In-First Out (FIFO), Last In-First Out (LIFO), and “Average Cost.” Each method has potential benefits and drawbacks, so consider which is best suited to your business, and consult an accounting professional if you are in doubt.
ASSESS AND IMPROVE YOUR BUSINESS USING COGS
While the calculation of COGS is straightforward, there are a variety of ways to look deeper into your COGS to evaluate the state of your business. Among these are:
Setting your prices correctly. As a business owner, you presumably have minimum and ideal profit margins in mind, and since COGS is a direct input into determining profit margin, it is also a valuable metric to determine how those margins can be reached. Are your prices high enough to recover your costs plus an acceptable or ideal profit margin? If you lowered your prices, could you potentially see an increased sales volume that would actually result in a higher profit margin?
Assess your operational efficiency. COGS is not simply impacted by the prices you pay suppliers, but also a variety of avoidable issues like damage in transport or storage, spillage, theft, overstocking (which keeps COGS too high), or understocking (which means you may overpay to get new inventory fast).
Are specific products impacting your profitability? By examining the COGS for various items in your inventory, you may find that the profit margins on some of them don’t justify the effort to produce or sell that item. You may choose to focus on more efficient products that maximize profit margins.
Can you improve the COGS for some of your inventory based on your lower-COGS items? By examining how some of your products have good margins due to low COGS, you may find that you have overlooked productive methods in the supply chains of your lower-margin inventory.
Minimize your tax burden while maximizing profits. COGS is tax-deductible, so the higher it is, the lower your tax burden. Of course, higher COGS cuts directly into your profits, so there’s obviously a limit, but there are ways to find an optimal balance between tax liabilities and income, so that you maximize your profits versus your tax liabilities. And be careful, as the IRS specifically keeps a close eye on COGS declarations in order to identify fraud.
SOME QUICK BUT EFFECTIVE COGS-BASED CALCULATIONS
In addition to the deeper analyses listed above, here are a few quick metrics you can calculate to get an idea of the health of your business:
Gross Margin = (Sales Revenue – COGS)/Sales Revenue x 100. This is the percentage of sales revenue you keep after costs are accounted for. The higher the percentage the better, and any changes over time should be investigated and understood.
COGS ratio = COGS/Net Sales x 100. Lower is better, as it indicates Net Sales are strong vs. production costs
Inventory Turnover = COGS/Average Inventory. When this number is too low, you are not moving inventory and are prone to overstocking.
As we’ve seen, Cost of Good Sold is more than just an entry on the income statement. COGS can help you examine, understand, and improve many aspects of your business. Owners and managers should regularly monitor it and use the clues it gives to become consistently more profitable.
If you’re looking for more insight on managing COGS, BKE can help. BKE offers bookkeeping and accounting services, along with reporting and payment solutions. … And that’s just the beginning. We’ll provide you a team of bookkeepers with expertise in your industry. We work with your existing accounting software& tools, but can also help you make the move to newer technologies.