Small business owners who look at balance sheets regularly are in the minority because there are many other demands on their time. Understandably, business owners would want to worry about staffing, marketing, and customer service before thinking about those columns of figures. However, business owners who wish to grow their business moving forward read and understand the numbers for the COGS. Do you know what COGS stands for and why understanding COGS is so important for the health of your business? Keep reading to get information to help keep your business moving.
What Is COGS?
The term COGS stands for Cost of Goods Sold. Your “goods” may be either goods or services you provide to your clients. You may have seen COGS as COS (Cost of Supplies or Cost of Services) as well. No matter which acronym you use, the figures for COGS are essential because they sum up how much it costs your company directly to produce your product or service.
The COGS numbers are a review of expenses for your company. Usually, the numbers are calculated for the same month you calculate your revenues. COGS numbers don’t include the costs of selling your product or administrative expenses. General business expenses (such as pencils) are usually not covered by the COGS numbers. Instead, you can find those numbers by the acronym SGA (Sales, General, and Administrative) or SG&A (Sales, General & Administrative on your balance sheet or on a profit and loss statement.
Why is COGS Important?
The numbers around the COGS are vital for your business. Because there are several numbers involved, let’s look at all the information in the COGS figures and why you need to look at the numbers closely.
Direct Materials
Direct materials represent how much you had to pay to make your product. Direct materials are consumable pieces that go into making a product to sell. People call direct materials raw materials because you must have these materials to make your product. For example, if you make chocolates to sell, one of your direct materials costs would be the cocoa powder you bought for your chocolate. Unlike most other cost numbers, the direct materials fluctuate up and down because the market drives it. The direct materials costs will be lower during some months than in previous months.
For example, gas prices at the beginning of the pandemic were less than $1.50 per gallon because no one was driving their personal vehicles. However, gas prices have skyrocketed with more people driving, the war in Ukraine, and the lack of supply to meet the oil demand. Because the gasoline prices have been so volatile, people who use gas as part of their business, such as landscapers, have seen their direct costs increase substantially over the last two years. Also, because transportation goods for all manufacturers have increased, you may notice you are paying more for raw materials than ever before because your suppliers are passing their increased expenses to you.
Direct Labor
Direct labor numbers show how much you had to pay employees who produce your product or service. If you owned a chocolate factory, direct labor costs would be for anyone employed to produce your chocolate. Direct labor costs can include full-time and part-time employees, as well as temporary employees, if you hired them during a surge in production. If you had employees who worked overtime in your product’s production, those numbers also need to be reported here. Remember that labor costs for sales and administrative people are not reported here.
There’s more to the direct labor cost than just salary or wages; all the payroll taxes for your employees also belong in the direct labor cost. You can also include figures for unemployment insurance, Social Security, and Medicare costs here.
If your company pays incentives or bonuses for great work or employee retention, you should be able to list those under direct labor costs as well. If you give your employees gift cards as an incentive, you cannot list that here since it isn’t money you paid out as wages.
Supplies
Not every business counts supply numbers in the COGS. However, if you have to use supplies to manufacture your product to sell, such as wrappers or packaging, you could put those figures in the supplies column.
There are several items you could list in your supplies figures, but they are usually broken down into two categories. First, there are your factory supplies. These are supplies that are needed in your manufacturing processes, such as those wrappers and packaging. Also, soap, cleaners, and janitorial supplies can be listed here as well. You may also have items such as hangers, silica, and other supplies used to prepare the product for shipping, such as boxes and labels.
What Is the COGS Used For?
Business owners need to be familiar with the COGS because they directly affect their businesses. First, the COGS is used as a marker for figuring out your business net income. Your net income is vital come tax time. If you want to use the COGS to make deductions on your business taxes and reduce your tax liability, you need to keep meticulous records of your monthly costs.
Second, businesses can use the COGS as another lens to look at their business’ overall health. If your business is spending less money to make the items you sell than it is taking in during sales, your gross profit margin will be higher, which signals that your business is healthy. Suppose your business is spending more money to sell the product than you are taking in for sales, especially over a long period. In that case, you may need to reduce your expenses to continue having a healthy business. Your gross profit margin is like a traffic signal for the health of your business.
Third, the COGS represents a line item on your profit and loss statement. Still, many potential sources of additional financing look at the COGS to decide whether or not to invest capital into your business. If you want to expand your business, for example, a lender is going to look at your COGS to see if you have healthy sales numbers to justify expansion.
Your COGS may also show deficits in your overall marketing and sales plan. For example, if the cost of your materials hasn’t risen substantially, and sales of your products remain fairly constant, but your business isn’t increasing its sales the way you would like, it may be time to look at your spending in sales to make sure you are getting your money’s worth from your sales department.
What Isn’t In The COGS
Your overhead is perhaps the largest expense that isn’t included in your COGS. Overhead costs are defined as those costs a business incurs each month whether they sell any of their product or service or not. Overhead costs would include the amount of rent or mortgage you pay on your office space, factory, or storefront. Utilities would be included in overhead costs as well.
Overhead costs include insurance for the building and contents because most small business owners need business insurance to do business. Many businesses also list office supplies not related to manufacturing here, and business owners also list large office costs here, such as computers, office phones, and office furniture. You might also list maintenance fees for the building and grounds here as well.
Why Should I Care About COGS?
It can be difficult as a business owner to interpret all of the figures swirling around your business. The larger your business grows, the more difficult it can be to take time to look at your business figures, especially in this economy. So many businesses are trying to reconfigure the cost of doing business in the pandemic era that it can be hard to look at numbers at the end of the day.
However, because your COGS directly relate to the health of your business, you need to create time to digest those numbers on your balance sheet. COGS can affect your cost of doing business for months and years into the future since the numbers are used as a business health checklist for lenders and insurance companies.
COGS and Its Role in Pricing Strategy
Understanding your Cost of Goods Sold (COGS) is more than just tracking expenses—it’s essential for setting the right price for your products or services. When small business owners grasp their COGS fully, they gain insights that can lead to better pricing decisions, competitive advantage, and profitability. Here’s how COGS can transform your pricing strategy.
Using COGS to Determine Optimal Pricing
Pricing too high can drive customers away, while pricing too low can eat into profits. Knowing your COGS allows you to set a price that covers production costs while achieving a healthy profit margin. This practice helps avoid underpricing, which can lead to thin profit margins, and overpricing, which may reduce demand.
For instance, if you know your product’s COGS is $10, you might aim for a 50% markup, setting your selling price at $15. This markup covers the cost and provides a cushion for profit, overhead, and any unplanned expenses.
Enhancing Competitive Edge with COGS Insights
In competitive markets, analyzing COGS helps you identify ways to reduce costs and offer better prices than competitors without sacrificing quality. Regularly reviewing your COGS can reveal opportunities to streamline processes, negotiate with suppliers, or improve production efficiency. By keeping costs low, you can price your products more competitively, drawing customers without sacrificing profitability.
Using COGS Data for Promotional Pricing and Discounts
COGS also plays a vital role in planning discounts and promotions. By understanding the minimum price needed to cover your production costs, you can offer discounts or run promotions without risking losses. This is especially valuable during peak seasons or when introducing new products, as you can strategically price products to attract customers without compromising on profits.
How Protea Financial Can Help with Pricing Strategy
Protea Financial specializes in helping businesses make sense of COGS and apply it to various aspects of financial strategy, including pricing. If you’re ready to optimize your pricing for profitability and growth, Protea Financial can offer insights tailored to your business needs. Connect with us today to start setting smarter prices and maximizing your business potential.
Turn to Protea Financial for Help Understanding COGS and How It Applies to You
If you don’t know how to read your business financials, including COGS, there are ways you can get proficient at it. You can begin by studying those financial terms online to get an introduction to financials. However, there are companies that help business owners make sense of all of those numbers. Protea Financial has been working with small business owners for nearly two decades. We can help you with bookkeeping, accounting, and inventory management. If you need help making sense of your business numbers, we can help. Contact Protea Financial today, and let us help you move your business forward today.
Understanding your Cost of Goods Sold, or COGS, is important. It is vital to keeping your business healthy! Contact us here at Protea Financial for help understanding it all!
