As a new business owner, understanding Costs of Goods Sold (COGS) is crucial for managing your business finances. COGS can seem like a complex concept at first, but with a bit of clarity, it becomes a powerful tool for measuring profitability and making informed decisions. In this guide, we’ll break down what COGS is, how it differs fromother expenses, and provide a real-world example to help illustrate its application in a service-based business.
What Exactly Is COGS?
COGS refers to the direct costs your business incurs to produce goods or deliver services. In simpler terms, it’s the money you spend specifically to create the product or service you sell. For businesses that sell physical products, COGS includes things like raw materials and production labor. In service-based businesses, COGS includes the direct costs tied to delivering your services.
For example, if you run an HVAC repair business, COGS would include:
- Materials (e.g., replacement parts, refrigerants).
- Labor costs specifically tied to the service (e.g., the wages of technicians working on the HVAC system).
- Costs of any subcontractors hired to help with the job.
COGS includes only the expenses directly associated with a particular service or job. The reason tracking COGS matters is that it helps you calculate gross profit:
Gross Profit = Sales Revenue - COGS
Gross profit shows how much money you’re making from your core operations after covering the costs of delivering your services or goods.
COGS vs. Other Expenses
To understand COGS fully, it's essential to distinguish it from other expenses, often referred to as operating expenses. While COGS covers the direct costs of producing a good or delivering a service, operating expenses are all the other costs involved in running your business. These include expenses that would still be incurred even if no goods or services were being delivered.
Here’s a breakdown:
- COGS (Direct Costs): These are the costs that directly relate to delivering your product or service. For an HVAC repair business, COGS includes parts and labor specifically for a job.
- Operating Expenses (Indirect Costs): These are expenses that are not directly tied to a single job or product. Examples include rent, utilities, marketing, and administrative salaries. These costs are necessary to keep the business running but don’t fluctuate with the volume of services you provide.
What About Salaries?
Not all salaries count as COGS. Here's the key difference:
- Direct Labor (COGS): If an employee’s work directly contributes to delivering a service, like an HVAC technician who installs or repairs equipment, their wages are considered part of COGS.
- Indirect Labor (Operating Expenses): Employees who perform general business tasks, such as administrative staff, office managers, or marketing personnel, are not part of COGS. Their wages fall under operating expenses because their work supports the business as a whole, not individual jobs.
It’s important to track these categories separately because it helps you understand the cost of delivering your services and ensures you're pricing them appropriately.
Why Understanding COGS Matters
Keeping track of COGS is essential for several reasons:
- Measuring Profitability: Knowing your COGS allows you to calculate your gross profit, which gives insight into how efficiently your business delivers its goods or services. If your gross profit margin is low, it may indicate that your direct costs are too high.
- Setting the Right Prices: Understanding your COGS ensures that your pricing covers the direct costs of delivering your services. If you don’t include all relevant costs in your pricing, you may undercharge and reduce profitability.
- Tax Deductions: In many tax systems, COGS can be deducted from revenue to determine taxable income. This reduces the amount of tax you owe and can lead to significant savings if tracked properly.
Example: COGS for an HVAC Repair Business
Let’s explore a real-world example using CoolAir HVAC Services, a fictional company that provides heating, ventilation, and air conditioning repair and installation services.
1. Air Conditioning Repair Job:
CoolAir gets a call to fix a malfunctioning air conditioner at a client’s home. The technician replaces a faulty compressor and refills the refrigerant.
- COGS: The cost of the new compressor ($300), refrigerant ($50), and the technician’s wages for the repair ($200) are all part of COGS. These are the direct costs tied to delivering this specific service.
- Operating Expenses: The monthly salary of the office manager who schedules appointments or the cost of the office’s internet service would not be part of COGS. These are operating expenses because they support the business in general, not this specific job.
2. HVAC Installation Job:
CoolAir is also hired to install a new HVAC system in a commercial building. The company buys the necessary equipment and sends a team to handle the installation.
- COGS: The cost of the HVAC system itself ($4,000), installation materials ($300), and the wages for the installation team ($1,500) are part of COGS. These are all direct costs related to the job.
- Operating Expenses: The salary of the marketing team that promotes CoolAir’s services and the utility bills for the office are not COGS. These costs continue regardless of how many HVAC systems are installed, making them operating expenses.
Tracking COGS in Your Business
Understanding COGS is just the first step. The next step is to accurately track your COGS to make sure your bookkeeping reflects the true cost of delivering your products or services. Here are a few best practices:
- Keep Separate Accounts: Set up separate bookkeeping accounts for COGS and operating expenses. This allows you to clearly differentiate between direct and indirect costs when reviewing your financials.
- Automate the Process: Use accounting software to track COGS automatically. Programs like QuickBooks or Xero allow you to label costs as COGS or operating expenses, making it easier to manage and review.
- Regular Reviews: Review your COGS regularly to ensure your pricing covers all direct costs and that your business is profitable. This also helps identify areas where you may be able to reduce costs or improve efficiency.
Understanding how COGS impacts your gross profit, and by extension, your overall profitability, is key to running a successful business. By knowing the difference between direct costs (COGS) and operating expenses, you’ll be able to make better pricing decisions, manage your finances more effectively, and ultimately grow your business more sustainably.
