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Imagine that you’ve just opened a subscription clothing box company. Your products are popular, and subscriptions are steady, even growing — but at the end of a few months, you’re puzzled about why you’re not turning a profit.
The explanation lies in knowing the difference between the cost of goods sold and gross revenue.
Many startups fail to account for the cost of goods sold — COGS. Forgetting COGS can cause major budget headaches and chronic overspending, negatively impacting your profits. In some cases, ignoring this key metric may cause new businesses to go under because they aren’t doing their financial or sales forecasting.
Find out more about managing COGS, including solid strategies to implement COGS even at the very earliest stages of your startup.
What Is Cost Of Goods Sold (COGS)?
Cost of goods sold, also known as “cost of sales (COS),” is the total cost of producing a good and making it ready for sale. Since every penny you spend on production impacts your bottom line, your company won’t show a profit if you don’t earn enough on sales to offset your expenses.
If you’re new to startup ownership, you may find accounting and budgeting challenging, especially in the beginning. You may overlook the calculation of your total expenditures and startup costs, resulting in underestimating your production costs and setting your prices artificially low.
This creates a vicious cycle in which you don’t realize enough profit and then keep lowering prices to increase sales.
What Costs Are Included In COGS?
Calculating your COGS can help you grow your business, attract investors, and set realistic prices. It can also highlight areas where you could lower labor costs and find lower-priced raw materials.
COGS includes all the raw materials, labor, and equipment (plus the utilities needed to run the equipment) you use to manufacture products.
1. Direct Materials
You need a supply of goods or materials to make your product. For example, if your company manufactures tracking technology for pet collars, purchasing computer parts to create the chips is a part of your total COGS.
If your COGS is too high, consider if you could get more affordable raw materials somewhere else. Many businesses are looking overseas for inexpensive materials to manufacture their goods at a lower cost.
2. Direct Labor
You may need workers to take your materials and assemble your finished product, so part of COGS includes how much you’re paying employees. Calculate the number of employees producing your goods and how long it takes them to figure out your accurate labor cost.
Consider whether you can reduce labor costs without reducing product quality. Automating tasks that require manual labor is a great place to start. Identifying bottlenecks can smooth out the process and lessen the time.
3. Manufacturing Overhead
This overhead is specific to manufacturing your products, not the overhead costs of running your business. Manufacturing overhead includes the cost of machinery, upkeep, repairs, and utilities to run the machine, such as electricity. Building rent, maintenance, and upkeep on factories all count toward manufacturing overhead.
If your manufacturing overhead is high, consider moving your operations to a lower-cost area.
Importance of Accurately Tracking COGS For Startups
It’s common for startups to track COGS incorrectly. In the excitement of building a new business, you may gloss over the costs involved in producing goods. It can also lead to overpaying for raw materials or wasting labor.
Accurate calculating and tracking COGS is a game changer for startups. It’s a clear, data-driven way to determine pricing and identify waste.
How To Calculate Cost Of Goods Sold
Calculate the cost of goods sold by relying on a simple formula:
COGS = Beginning Inventory + P − Ending Inventory
In this formula, “P” represents all purchases made while producing the goods in question.
Knowing which purchases to “count” toward COGS can sometimes be challenging. As a general rule, ask yourself whether you would have made the purchase even if you weren’t producing this particular good.
Relevance For Startups: 5 Key Considerations
Some entrepreneurs believe that they don’t need to worry about COGS, thinking that COGS is a concern only for larger companies. But that’s false! COGS is a crucial metric for every business, large or small.
Here’s why and what to keep in mind as a startup:
1. Operating Expenses vs. COGS
Operating expenses (OpEx) measure how efficiently you run your business. In contrast, COGS looks at particular elements, like pricing and supply costs. However, both are important metrics.
On its own, OpEx doesn’t provide a granular view of your company’s profits and losses. COGS has a significant impact on OpEx, simply because COGS makes up such a substantial portion of OpEx.
2. COGS And Pricing Strategy
When you know how much production costs, you can adjust your retail prices to reach profit goals. COGS can also help plan for taxes and impact staffing and scaling decisions.
3. COGS And Financial Forecasting
COGS is important for determining your real-time profits, but it also plays a role in foreseeing profits. You can use these predictions to budget for supplies and other business operations.
4. Impact On Profit And Revenue
COGS takes the focus away from the sheer number of sales and turns it squarely onto real profit and revenue, boosting the bottom line by making startup owners more aware of their current financial situation.
5. Impact On Startup Taxes
The IRS allows you to report COGS on your tax form (Form 1125-A), offsetting your tax burden. Keep reading here for more about startup taxes.
Cost Of Goods Sold For SaaS And Services Startups
Not every business uses COGS as a metric. For example, service-based businesses and SaaS companies look at the cost of services, a similar metric, by measuring the cost of offering a particular service to customers.
Elements of cost of service include:
- Hosting
- Labor to keep the service in operation
- Labor for customer and technical support of the service
- Other software required to deliver your service
SaaS companies should avoid calculating sales commissions, including upselling, production management, and software development costs, while determining their cost of service.
Recording COGS Using Different Accounting Methods
Depending on your preferred accounting system, there are several ways to record COGS. Some of the most popular methods of tracking COGS include:
- First-In, First-Out (FIFO) – Expensing your older inventory for production before your newer supplies.
- Last-In, First-Out (LIFO) – Expensing the most recently produced products.
- Average Cost Method– Averaging all of your purchased inventory to determine the cost of goods already sold and the cost of goods yet to sell.
- Specific Identification – Instead of grouping goods and products together, you’re assigning costs to individual elements of inventory by keeping track of each unit.
There’s no one right solution. Use the method that works best for you and your team.
Strategies For Managing COGS As An Early-Stage Startup
It may take some time for you to manage COGS effectively. But there are a few ways to help adjust quickly:
- Accurately track and report COGS by tracking inventory monthly and in real-time. You need to know how much inventory you have, when you’ll need more, and how much more that will be.
- Identify opportunities for cost savings. Ask yourself if unnecessary elements of your business can be eliminated. How can you improve production efficiency? Can you negotiate with vendors on lower prices for supplies? Reducing the cost of your production without sacrificing quality will improve your bottom line.
- Utilize accounting services. The expertise of cost accounting services helps you narrow in on your production expenses — where you can save and where you should spend.
It’s Too Early For My Startup To Start Managing COGS
It’s never a waste of time to track COGS, even in your startup’s early days with barely any inventory. Even if you’re already tracking inventory, you may be curious why you need to track COGS, too.
COGS management can help you create a sustainable business model. It lets you see if you’re pricing your goods appropriately or need to make changes. You can predict your earnings to see how you can grow your business. The sooner you track COGS, the sooner you can make adjustments for business success.
Improving Profit By Monitoring Cost Of Goods Sold
No matter where you are in your startup business, you need to track your cost of goods sold to eliminate wasteful spending while maximizing profits. Know how your materials, labor, and overhead affect your COGS.
Use a COGS method to set realistic pricing, predict your financial growth, and get the most out of your tax filings. Of the various COGS methods, use the one that works best for your business, even if it means doing “trial and error” to figure that out.
But overall, consider how the right automated software tools can best assist you.
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