An introduction to cost of goods sold

I recently had a call with an individual who helps stabilize distressed companies, and in the course of our conversation he mentioned that it’s important for him to understand what a client’s cost of goods are like.  That’s an excellent point, and one that I think needs to be brought into our conversations about finance.  For one thing, cost of goods is an expense, and like any other expense it’s important to keep an eye on it and control it.   Further, as you’ll see later… possibly in the next post, now that I think about it, cost of goods sold factors into key decision-affecting calculations.

Let’s start with the basics by asking what cost of goods sold, abbreviated COGS, is.  In short, cost of goods sold is what is costs to make money.  If you sell lemonade, it’s how much you pay for lemons, sugar, and water.  If you are a retail shop, it’s the cost of inventory.  If you drop ship goods, it’s how much you pay your supplier.  If you’re a manufacturer, it’s the cost of raw materials, the cost of labor to turn those materials into finished product, and the factory in which they are made.  Even service businesses have cost of goods sold, but these are referred to as cost of services sold.  Things within cost of services sold might include staff, contractors hired for that big software implementation, or the monthly software-as-a-service plugin subscription needed for a client’s system.  What do these all have in common?  The business would not have a product or service to sell without them.

If we think about it further, there’s an important distinction to make among all of these examples, and it’s not physical good versus service.  Looking back at the factory example, you’ll notice that I listed a number of cost types: materials, labor, and factory.  For example, every day people come in to the building, pour materials into molds, dishes are baked in a kiln, and out come the finished product.  Some days the factory makes 3,000 dishes, other days 6,000 dishes.  The business pays its people no matter how many dishes are made, has to pay the mortgage on the factory regardless of how many dishes are made, and so on.  However, the cost of the ceramic compound goes up or down depending on how many dishes were made.  The costs that the business pays regardless of volume are considered fixed cost of goods, whereas the cost of the materials that varies are known as variable costs of goods.

By way of another example, let’s say that there are two computer repair companies; one uses people on payroll, the other uses contractors as demand requires (ignore the potential Department of Labor issues for a moment!).  Every month, the firm with staff has to meet payroll, regardless of whether there’s even a sale or not.  So it has fixed costs.  On the other hand, the firm that uses contractors pays more when it makes more and pays less when sales go down.  This firm has variable costs.

This is partly what clues us in to the importance of understanding what cost of goods / cost of services is: what kind of planning, what kind of decisions, and what kind of business model will all be affected by how much costs are and whether they are fixed or variable.  A business without a track record will likely want variable costs so that it doesn’t have to meet a fixed payroll every month, even if the cost per unit is more.  A business that has been a business a long time, has a proven business model, and is confident in its ability to generate sales is more likely to invest in a factory and build a staff.

This is enough to cover what I wanted in the introduction, so I’ll stop here for now.  I’m going to cover more of this topic in my next post by showing how we use the numbers to make very important calculations based on variable costs.