Cost of Goods Sold (COGS)

Definition

The Cost of Goods Sold (COGS) represents the direct costs associated with the production of goods that a company sells. In simpler terms, it’s how much a business spends to make or buy the items it sells. This includes raw materials, labor costs directly tied to product creation, and any other direct factory costs. It doesn’t, however, include indirect cost such as sales and distribution costs.

Why is Cost of Goods Sold Important? 

COGS isn’t just a figure on an income statement; it’s important for several reasons:

• Profitability: Subtracting COGS from revenues gives the gross profit, a primary indicator of a company’s core profitability.
• Pricing Strategy: Understanding COGS can help businesses set pricing to achieve desired margins.
• Tax Implications: COGS is deductible, which means it can reduce a company’s taxable income, leading to potential income tax savings.
• Operational Insights: It can help small businesses identify inefficiencies in their production processes or supply chain.

Diverse Approaches to Cost of Goods Sold 

There are multiple ways to approach COGS, depending on the business model, industry, and inventory management method:

• First-In, First-Out (FIFO): Assumes the oldest items in inventory are sold first. It’s commonly used during periods of steady or rising prices.
• Last-In, First-Out (LIFO): Assumes the newest items in inventory are goods sold first. It can be beneficial in inflationary periods.
• Average Cost Method: Calculates a weighted average cost per unit for the entire inventory, which is then used to determine COGS.
• Specific Identification: Ideal for businesses with unique, high-value items, this method tracks the exact total cost of each item sold.

Crunching Numbers: Calculations and Formulas of COGS 

Calculating COGS is essential for any business dealing with physical products. Here’s the basic formula:

• Beginning Inventory: The value of the inventory at the start of a period (e.g., the beginning of the month or year).
• Purchases: All additional goods sold purchased during that period.
• Ending Inventory: The value of the inventory at the end of the period. For a practical example: Let’s say a business starts January with $5,000 worth of inventory, purchases an additional $3,000 throughout the month, and ends January with $4,000 in inventory. Using the formula: Thus, the COGS for January would be $4,000.

This foundational knowledge of COGS, its significance, various methods, and how to calculate cogs is crucial for both budding and seasoned business professionals. In forthcoming sections, we’ll explore the intricacies of its relationship with pre-planning and how it shapes business planning endeavors.

The Relevance of COGS in the Pre-Planning Stages

Before launching into detailed business planning, entrepreneurs engage in a crucial pre-planning phase. This is a reflective and analytical period where ideas are refined, markets are assessed, and foundational aspects of the business concept are shaped. Essentially, it’s the groundwork that determines if the business idea is viable. One key metric that plays an influential role during this phase is the Cost of Goods Sold (COGS). Let’s examine its role across the various stages of pre-planning:

How Does COGS Relate to Pre-Vision Interviews? 

In the context of pre-vision interviews, the primary focus is on understanding the functional, emotional, and social problems that potential customers face with current market solutions (i.e., the products and services they are using now to solve their problems, meet their needs, or get their jobs done). While COGS might not directly inform these discussions, there’s an indirect relationship:

• Pricing Feedback: Though the interview’s emphasis is on problems solved by current market solutions, sales tax or promotional pricing can emerge in conversations. Understanding COGS can offer context to these pricing insights.
• Product Quality and Features: While discussing switching behaviors, customers might highlight compromises made by competitors’ products or services. Though COGS isn’t the central theme, it can influence the quality or features a competitor offers.
• Identifying Market Gaps: If customers hint at a desire for more affordable or value-driven alternatives, an entrepreneur can use COGS or Core Costs analysis to identify opportunities and understand if they can competitively meet this demand.

How Central is COGS in the Core Cost Analysis?

Cost of Goods Sold (COGS) is critically important when analyzing core costs. Yet, in different contexts, it’s merely one element among many. Core costs depict what’s required to deliver the core offering, capturing the way in which a customer will experience the product or service. Consider:

• Simple Products: In cases like a can of soda, core costs largely depend on COGS—ingredients, production, and packaging.
• Complex Experiences: Take a small business like a restaurant. Here, COGS is only a part of the story. The ambiance, direct labor of the staff, and overhead costs related to the restaurant’s setup all shape the experience.

Is COGS Important in Business Model Brainstorming?

During early planning, especially using tools like the Business Model Canvas, the focus is on sketching the business model rather than diving deep into the income statement. However, COGS can guide this process:

• Revenue Streams: As you think about revenue, understanding how to calculate COGS can influence initial pricing and sales thoughts.
• Cost Structure: Even without exact figures, COGS provides a lens to view broader costs.
• Value Propositions: An early grasp of COGS can hint at competitive edges based on pricing or product features.

Deep Dive into Key Partners, Activities, and Resources

When digging into foundational business operations, COGS isn’t just an isolated figure. It’s intricately connected to various parts of the business:

• Key Partners: For a company to maintain a competitive edge, it’s imperative to foster robust collaborations with key partners. This can include suppliers, third-party manufacturers, third-party-logistics, and many other product and service providers. By establishing agreements such as bulk purchasing and shared manufacturing processes, a company can benefit from volume discounts, streamlined production, and reduced logistical costs. These partnerships, when well-negotiated, can have a substantial impact on lowering a company’s COGS, enabling it to offer more competitive pricing and achieve better margins.
• Key Activities: Streamlining processes directly impacts COGS. The aim is to ensure quality while managing production operations costs.
• Key Resources: Decisions about essential resources can sway COGS. Choices like leasing vs. buying or insourcing vs. outsourcing become significant.

Startup and Operating Cost Analysis

For new small businesses and startups, estimating starting expenses is vital, with COGS at the forefront:

• Inventory Purchases: For product-focused businesses, the initial stock’s cost is significant.
• Production Operations: Direct costs tied to production, such as raw materials and direct labor, factor into COGS.
• First Three Months: Predicting COGS helps in budgeting, essential for managing cash flows during a startup’s early days.

By this phase, a clear grasp of COGS is crucial. If there’s any ambiguity, more research is needed to understand the expenses associated with preparing your product or service for the market.

COGS is not just a singular metric in an income statement. Its ramifications span across various sections of a new small business or a startup’s business plan, influencing strategies, forecasts, and competitive positioning. Understanding and effectively managing COGS can significantly enhance the appeal of a business to stakeholders, lenders, and potential investors.

Cost of Goods Sold in The Business Plan

At the heart of any successful business endeavor lies a robust business plan. This document serves as a roadmap, outlining the company’s vision, mission, objectives, and the strategies devised to achieve them. For a new small business or a startup, especially those eyeing investment, a business plan isn’t just a guide; it’s a tool for securing required capital, supporting initial cash flow and showcasing the viability and net income potential of the venture. One pivotal metric that threads through numerous sections of this document is the Cost of Goods Sold (COGS). Let’s delve into its significance across various sections.

Should I Mention COGS in My Executive Summary? 

While the executive summary is brief, mentioning COGS can be strategic in some cases. It could, for example, provide potential investors with a glimpse of your direct cost efficiency and potential profitability. A competitive COGS, when compared to industry averages, can pique interest right from the start.

How Does COGS Shape My Legal and Financial Details? 

• Financial Highlights: COGS directly influences the gross margin, a figure that investors often scrutinize. Highlighting an efficient COGS can demonstrate good management and profitability potential.
• Operating expenses also tie into this narrative. Sources and Uses of Funds: Any funds allocated to reduce COGS (like investing in efficient machinery) can impact adjust free cash flow and should be specified.
• Legal and Location Details: The company’s location can indirectly influence COGS by impacting inventory costs. Specifically, shipping costs associated with transporting materials to the company’s location are integrated into inventory costs, which in turn factor into COGS. Furthermore, choosing specific legal structures might present the Company with net income tax advantages connected to these inventory and COGS considerations.

Is COGS Central to My Company Description? 

• Products & Services Description: Detailing your offerings provides context for COGS and COGS calculation. For example, high-quality products may justify higher Cost of Goods Sold.
• Competitive Advantage: An efficient COGS can be a competitive edge, allowing for competitive pricing or higher net cash margins.

Does COGS Drive Insights in My Market Analysis? 

• Trends: If market trends lean towards cost-effective or premium products, COGS can inform product positioning.
• Competitive Comparison: Assessing competitors’ pricing and products can offer indirect insights into their COGS, highlighting potential market gaps.
• Target Market Analysis: If the target audience is price-sensitive, managing COGS becomes paramount. The fiscal year can also impact purchasing behaviors for seasonal products.
• Industry Analysis: An industry’s average COGS can set benchmarks for businesses to aim for or surpass.

How COGS Influences Strategy & Implementation 

• Marketing Strategy: COGS can shape how deeply a company can discount for price promotions, especially if businesses want to highlight value propositions related to cost-effectiveness or premium quality.
• Sales Strategy: Sales tactics might vary based on how COGS influences product pricing.

The Impact of COGS in Financial Forecasts 

• Revenue Projections: COGS plays a role in determining the gross profit, which impacts revenue estimates and adjust free cash flow.
• Key Assumptions: When forecasting, assumptions about potential COGS fluctuations due to market changes, supplier agreements, or efficiency measures are vital. Operating expenses should also be considered.
• Expense Forecasts: COGS is a significant part of the expense forecast, influencing projected profitability.

COGS’s ramifications span across various sections of a business plan, influencing strategies, forecasts, and competitive positioning. Understanding and effectively managing COGS can significantly enhance the appeal of a business to stakeholders and potential investors

The Impact of COGS Across Diverse Business Models

The Cost of Goods Sold (COGS) is a ubiquitous metric across businesses, but its specific components and relevance vary depending on the business model. By delving into a variety of traditional and modern business types, we offer readers a clearer understanding of how COGS impacts operations and financial modeling structures. Let’s explore some examples.

Traditional Small Businesses

Product-based Company (Artisan Bakery)

• Raw Materials: Flour, sugar, eggs, and other goods.
• Direct Labor: Wages of bakers and staff directly involved in making the products.
• Manufacturing Supplies: Baking sheets, tins, utensils, etc.
• Utilities: Electricity and gas for baking ovens.
• Packaging: Boxes, labels, and bags for the goods sold.

Service-based Company (Dental Office)

1. Materials: Dental fillings, anesthetics, etc.
2. Consumables: Cleaning tools, gloves, masks, sterilization pouches.
3. Direct Labor: Salaries of dentists and dental hygienists.
4. Equipment Depreciation: In some accounting methods, depreciation of dental chairs, x-ray machines, and other long-term equipment.
5. Utilities: Electricity for equipment and lights.

Modern Startups

Product-focused Startup (Wearable Smartwatch)

• Component Costs: Microprocessors, sensors, display, battery, and other components that determine the total cost.
• Direct Labor: Assembly line workers or engineers for hand-assembled pieces.
• Prototyping: Initial versions for testing and refinement.
• Manufacturing Equipment: Depreciation on any specialized machinery.
• Packaging and Distribution: Boxes, instruction manuals, shipping for the goods sold.

Software Solution (CRM)

• Server Costs: Cloud hosting or expense related to data center expenses.
• Software Licenses: Third-party solutions integrated into the platform.
• Development Labor: Salaries or wages of software developers, designers, and QA testers.
• Maintenance: Ongoing updates, patches, and server upkeep.
• Customer Support: Operating expenses associated with training and maintaining a support team.

While COGS is a consistent metric across businesses, its specific components and categories can be shaped by the nature and nuances of each business model. In some instances, the distinction between categories, such as materials and consumables, can be subtle and might not always be essential, depending on the desired level of detail. For the purposes of business plans, financial models, and accounting, the paramount concern is maintaining consistency in how costs are categorized and tracked. By understanding how to  calculate COGS accurately within a specific model, businesses not only ensure better financial management but also provide sharper insights to stakeholders.