Yes it’s that pesky numbers person again.  Wanting to talk to you about analyzing and calculating.  Boring.  Or is it?

Profit is sexy right?  Don’t you get excited when you think about your business hitting the million dollar mark for the first time?  Profit is the fun, exciting and sexy goal all entrepreneurs seek.

Finance, including those pesky calculations, is the engine that will get you there.  Every engine needs certain things; gas, timing belt, transmission, coolant…  Cost of Goods Sold (COGS) is an important part of your profit engine.

COGS drives profit, profit is sexy, therefore COGS is sexy.  You heard it here first, COGS is hot, and it’s time you got to know more about it.

What Exactly is COGS?

When I lift up the hood of my car I can identify a few basic things – the oil dipstick, the place to add windshield wiper fluid, even how to change out headlights.  Calculating your COGS is like changing the headlights on a car.  A little tricky the first time, then it’s easy and illuminating.

Cost of Goods Sold includes only the expenses directly attributable to creating the product or service. 

In other words, Cost of Goods Sold includes all the expenses that are involved in making your awesome product or delivering your incredible service.  If you hadn’t created a product or provided a service you wouldn’t have this expense.

Why is COGS important?  It tells us the expenses we are going to have every time we make a sale.  That’s a critical factor in setting your price.  In addition there are tax implications of COGS.

Common expenses to include in COGS:

  • Raw materials
  • Direct labor costs

Common expenses not included in COGS:

  • Office rent
  • Marketing & branding
  • Sales expenses, including commissions

From a tax perspective you can find more details on calculating COGS on the IRS website here.

How COGS Relates to Profitable Pricing

Compare your COGS to your pricing.  If your price is lower than your COGS, that means every time you sell something you’re losing money.  Think this can’t be you?  Think again.  I see this all the time.  Take a few minutes right now and check it.

Let’s assume you have a price that is higher than your COGS.  Whatever is left must cover all your overhead, general labor and deliver a profit.  This is where volume does matter.  If your product or service only leaves $1 after COGS, you need to sell like crazy to cover overhead and generate a profit.  However, if your product or service has $10,000 after COGS, then a goal of selling 100 units is reasonable.

This quick-and-dirty analysis provides an easy litmus test to see if your pricing and volume expectations are realistic.  Note: If you have a low-volume business, your price better have a substantial margin over your Cost of Goods Sold.

Uncle Sam and COGS

The calculation of COGS has a direct impact on your tax situation.  Cost of Goods Sold is considered an expense, therefore the larger it is, the lower your taxable income.  This is something the IRS can and does audit to ensure your reported business income is not artificially low.  Be sure to keep clear records, using a consistent process from year to year.

There is another, less obvious, tax implication to Cost of Goods Sold.  If your business carries inventory, the value of your inventory at yearend is calculated using Cost of Goods Sold.  Your inventory may be taxable.  Be sure to discuss this with a tax professional.

Final Thoughts

Have you added COGS to your top 100 sexiest finance topics?  Were you surprised by the result of looking at your COGS?  What (if any) changes do you expect to make because of this analysis?