Exposing which costs legitimately belong in your COGS calculations versus those masquerading as production expenses that should be banished
Exposing which costs legitimately belong in your COGS calculations versus those masquerading as production expenses that should be banished
There are few metrics that matter more in the world of financial management than Cost of Goods Sold - aka COGS.
This crucial figure serves as the gold standard for measuring business profitability and ultimately drives key operational decisions across companies.
A lot of businesses already track their revenue diligently. But those who fail to master their COGS?
Well, they often struggle with pricing strategies, inventory management, and, ultimately, sustainable growth.
Not a COGS expert yet?
No problem!
Read on to find out why mastering your Cost of Goods Sold is the key to unlocking smarter decisions, higher profits, and long-term business success.
The basic COGS formula appears deceptively simple:
COGS = Beginning Inventory + Purchases - Ending Inventory
For example, if a furniture store generates $200,000 in revenue with a COGS of $160,000, its COGS ratio would be 80%
This foundational formula requires careful inventory management and consistent valuation methods to ensure accurate results.
The components of COGS vary significantly across industries, as each industry will have a different goods mix:
COGS includes the purchase cost of merchandise, inbound freight, customs duties, and other costs directly tied to acquiring inventory.
Usually, it expands to include raw materials, direct labor costs, and manufacturing overhead like factory utilities and depreciation of production equipment.
While service companies don't sell physical products, they may still have direct costs tied to service delivery, such as contractor payments or digital materials used in service provision. COGS might be a bit more abstract here, but it can still be calculated.
These components must be properly identified and consistently tracked to ensure accuracy in financial reporting.
Gross profit, calculated as Revenue minus COGS, represents the profit a company makes after deducting the costs associated with producing and selling its products.
But what does this metric reveal?
Pointedly, a company's efficiency in managing production costs before accounting for operating expenses.
It’s basically like saying, “Here’s the lump sum of money made after subtracting the cost of the actual ‘materials’ that went into producing the product.”
A higher gross profit margin indicates strong pricing power, efficient cost management, or both.
A declining one?
Often signals pricing pressure, rising input costs, or production inefficiencies that require immediate attention.
For example, if a retail business generates $500,000 in revenue with COGS of $300,000, its gross profit is $200,000, yielding a gross margin of 40%. Comparing this figure to industry benchmarks and historical performance provides valuable insights into a company’s operating efficiency.
COGS serves as the foundation for pricing decisions.
Without an accurate understanding of product costs, businesses risk underpricing products and services, which erodes margins. Similarly, they risk overpricing these and losing sales volume.
Strategic pricing requires a clear view of both direct and indirect costs.
Many businesses make the mistake of basing prices solely on competitors' pricing without understanding their own cost structure. This approach can lead to unsustainable pricing models and margin compression.
Dynamic Pricing could be a powerful tool for margin optimization, but only when it's built on accurate cost data that tells you exactly how low you can go in different market conditions.
Tax reporting is essential when it comes to COGS.
Since it directly reduces a company’s taxable income, reporting COGS accurately ensures that you don't pay your taxes that you arent supposed to pay - all by legitimizing legal tax deductions!
Keep in mind that Tax authorities scrutinize COGS calculations, particularly regarding inventory valuation and cost capitalization policies.
That means although COGS creates a tax benefit, consistency in accounting methods is essential to withstand potential audits.
There are so many growth opportunities brought up from COGS analysis.
We recommend paying attention to:
While the COGS formula itself is straightforward, implementing proper inventory tracking and financial reporting systems requires expertise.
Many growing companies find value in hiring a fractional CEO or interim CEO to establish robust financial procedures and reporting mechanisms.
Why bring one on?
Well, these experienced executives can work alongside a controller to ensure that COGS and other financial data are accurately tracked, reported, and analyzed.
They don't call for the full-time commitment of hiring a CFO, which is a huge financial commitment that not all companies can even bite off.
A fractional leadership approach allows companies to access executive-level financial expertise, particularly during growth phases or financial restructuring periods when proper COGS management can significantly impact profitability.
The FIFO method assumes that inventory items purchased or produced first are sold first. This approach generally reflects the natural flow of inventory for most businesses.
The first bits of inventory in is the first out, the last in is the last out.
During inflationary periods, FIFO typically results in lower COGS and higher reported profits, as older, less expensive inventory costs are allocated to goods sold first. While this presents more favorable financial results, it also increases tax obligations.
FIFO provides a more current inventory valuation on the balance sheet, as the ending inventory reflects more recent purchases. This method works particularly well for businesses dealing with perishable goods or products subject to obsolescence.
Although FIFO and LIFO rhyme, they happen to be opposites.
LIFO assumes that the most recently acquired inventory items are sold first. While less common than FIFO, this method offers certain advantages in specific situations.
During periods of rising costs, LIFO results in higher COGS and lower reported profits, potentially reducing tax liabilities. This tax advantage explains why some businesses prefer LIFO despite its divergence from typical physical inventory flows.
The downside?
However, LIFO can lead to outdated inventory values on the balance sheet and is prohibited under International Financial Reporting Standards (IFRS), limiting its use for global companies.
FIFO and LIFO's younger sibling.
The Average Cost method, sometimes called weighted average, calculates the average cost of all inventory items available during the period. This method strikes a middle ground between FIFO and LIFO.
The formula applied is:
Average Cost per Unit = Total Cost of Goods Available for Sale / Total Units Available for Sale
The best thing about this approach is that it smooths out price fluctuations and is less susceptible to manipulation than other methods.
It's particularly useful for businesses dealing with homogeneous products or commodities where individual units are indistinguishable.
For example, producing one specific boxed food item or raw good.
The Average Cost method simplifies record-keeping, making it attractive for businesses with high transaction volumes or limited accounting resources.
The most picky and complicated of all these methods,
The Specific Identification method tracks the actual cost of each inventory item individually.
This highly accurate approach works best for businesses selling unique, high-value items like automobiles, jewelry, or custom machinery.
We're talking custom-made, complicated, specific manufactured items that take many, many parts and follow a detailed and complicated manufacturing process.
While providing the most precise COGS calculation, this method requires sophisticated inventory tracking systems and detailed record-keeping. The administrative burden makes it impractical for businesses with high-volume, low-value inventory.
Direct materials encompass all raw materials and components that become part of the finished product.
For a furniture manufacturer, this includes wood, fabric, fasteners, and finishing materials. For a food producer, it includes ingredients, packaging, and labeling materials.
Tracking direct materials requires robust procurement and inventory management systems. Many businesses implement material requirements planning (MRP) systems to optimize material ordering and usage.
Direct labor refers to wages, benefits, and payroll taxes for employees directly involved in manufacturing products or delivering services.
This includes production line workers, assembly technicians, and quality control personnel who handle the product.
They are on the manufacturing floor, in front, and in direct contact with the product. This differs from C-suite executives, HR teams, or company salespeople.
A small caveat, though, as in service businesses, direct labor might include billable consultant hours or technician time directly attributable to specific customer engagements.
They aren't building a physical product, but they are still in direct contact with supplying the end product. For example, for a Sass company those developing the software would be considered direct labor.
As automation increases across industries, many businesses see shifts from direct labor costs to overhead or capital expenditures. COGS begins to take a back seat as manufacturing changes in form.
These transitions require careful accounting treatment to maintain accurate COGS calculations.
Manufacturing overhead encompasses all indirect costs associated with production facilities. These costs include:
Allocating manufacturing overhead to specific products presents accounting challenges, especially for businesses with diverse product lines.
The following costs, which are still business costs, are not directly related to the development or manufacturing of the product and therefore are excluded from COGS
SG&A expenses support business operations but don't directly contribute to product production. These costs include:
The distinction between manufacturing overhead (included in COGS) and SG&A expenses requires careful judgment. For instance, a production facility manager's salary typically counts as manufacturing overhead, while the CEO's compensation falls under SG&A.
Misclassifying SG&A expenses as COGS distorts gross margin calculations and can mislead management about true product profitability. There are also, of course, those tax implications to watch out for.
Despite their importance to product creation, R&D costs generally fall outside COGS calculations. These expenses include:
For example, a biotech company might have a few years of high-level R&D and Capex before even beginning to raise its COGS expenditures.
While excluded from COGS, these expenses represent critical investments in future product development and competitive advantage.
Other costs excluded from COGS include:
Businesses sometimes struggle with borderline costs that could reasonably fall within or outside COGS. In these cases, industry norms, materiality considerations, and consistency in application should guide classification decisions.
Imagine a small t-shirt shop:
With FIFO, you sell the oldest inventory first:
Remaining inventory: 50 shirts at $20 each = $1,000
Same scenario, but now lets look at selling the newest inventory first:
Remaining inventory: 50 shirts at $10 each = $500
The difference between methods is clear: LIFO produces a higher COGS ($4,000 vs. $3,500) and lower ending inventory ($500 vs. $1,000) in this period of rising costs. This illustrates why businesses might prefer one method over the other for financial reporting and tax purposes.
Since service-based COGS can be a bit more ambiguous, let's look at an example.
Let's consider the ABC consulting firm with the following costs:
Only the first three items ($57,000 total) would be included in COGS, as they directly relate to service delivery. The remaining $33,000 represents SG&A expenses.
If the firm generated $120,000 in revenue, its gross profit would be: $120,000 - $57,000 = $63,000 (52.5% gross margin)
COGS shows up differently across financial statements, which is something that your CFO should easily be able to pick out :
On the income statement, COGS appears immediately after revenue and is subtracted to calculate gross profit.
So revenue can be seen as the raw number that shows how much the business brought in, in real dollars. But revenue does not equal profits. Cost is always associated with this first.
This prominent position emphasizes its importance in profitability analysis.
The income statement typically presents:
Revenue $500,000
Cost of Goods Sold $300,000
--------------------------
Gross Profit $200,000
This structured presentation allows financial statement users to immediately calculate the gross margin percentage (40% in this example), a key performance indicator that facilitates comparisons across time periods and against competitors.
COGS directly impacts the balance sheet through inventory valuation.
The ending inventory from the COGS calculation becomes a current asset on the balance sheet.
Inventory typically represents a significant portion of current assets for product-based businesses.
Accurate COGS calculations ensure proper inventory valuation, directly affecting financial ratios like the current ratio and quick ratio that measure the liquidity of a company.
Holding too much inventory is costly, but having a safety stock is always important to prevent those pesky stockouts.
And the COGS ratio can really play into how much inventory costs and how it affects the bottom line.
For example, if a business is able to reduce its COGS ratio to 70% by streamlining the manufacturing process and finding a cheaper supplier, it would earn an additional $20,000 of profit without increasing revenue, a 50% increase from its original gross profit margin.
Regular COGS management might seem like a dragging accounting exercise, but analyzing this number gives businesses a key insight into their internal operations and company cost structure.
A successful business can beat out competitors in terms of number of sales and money made, but without control over costs, it comes out with the lowest revenue of all.
Effective COGS management requires regular review and analysis. Leading companies implement:
These reviews should include cross-functional participation from finance, operations, procurement, and sales teams to ensure all perspectives are considered.
Accurate COGS calculations depend on meticulous record-keeping. Best practices include:
A CFO or Controller can work in tandem to ensure all financial data is accurate, timely, and compliant with accounting standards.
There are great coaching programs available to CFOs to bolster their understanding of cost accounting and COGS methods and implementation, including training that can extend to an organization's entire financial team to ensure COGS is properly calculated, allocated, and analyzed for strategic decision-making.
Beyond compliance and reporting, COGS data should drive strategic decisions like:
Companies that master their COGS calculations gain a clearer window into true product profitability, make decisions based on insights rather than hunches, and pinpoint exactly where operational improvements will have the greatest impact.
The reward?
Not just healthier margins today, but a financial foundation that supports sustainable growth for years to come.
Is your company’s COGS measuring up?
In a financially healthy company with proper allocation of expenses, COGS should generally be in a range of 50% to 65% of sales.
If you're not there today, don't worry.
Reach out to us at McCracken Alliance to discuss how fractional CFO expertise can help you dissect your cost structure, identify improvement opportunities, and build the financial clarity that drives profitable growth.
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