Navigate Cost of Goods Sold (COGS)

Navigate Cost of Goods Sold (COGS)

So you’ve launched your business, congratulations! But as you begin your journey, you’ll realize one thing very quickly – in order to start earning and making money, you’ll need to spend money first.

As you go, you will realize that this adage is very true when it comes to business.

The most basic expense you will incur is the cost of making your product/service – otherwise known as the cost of goods sold (abbreviated as COG). Whatever your industry, whether it’s a SaaS-related business, or a brick-and-mortar mom and pop shop, or a seventh-generation family furniture maker, the Cogs’ idea applies – namely, that everything you sell, there is cost, in order to be made in the first place.

In this article, we’ll cover the basics of the cogs and everything you need to know.

Contents

What is COGS?

The importance of cogs

How to manage your cogs

What is COGS?

So, as we covered briefly earlier, COGS stands for Cost of Goods Sold. These are the direct expenses that are incurred in the process of producing, manufacturing or manufacturing your product and/or service.

The actual expenses that are classified as COGS vary from company to company. For example, a computer manufacturer’s COGs would involve all of the machinery, software, tools, and equipment needed to create the watches. If you are a computer seller (a retailer of computers), your COGs would be the cost of all the units you would acquire.

If you were a SaaS company, your COGs might include expenses such as hosting for your software or APIs if you pay for it, which will be used in your product.

In the course of business, it is normal and even expected that your cogs will increase as your income increases. Indeed, if you are selling more product, then logically you should also be producing more product (however, this may very well vary depending on the type of business model you have).

If we revisit our example of computers to illustrate this – the more computers you sell, the more computers you will need, meaning the more materials you will need to purchase and secure, in order to produce the additional goods required.

Let’s illustrate the use of some numbers. If the cost of making a single computer is and your business sells 1,000 watches in the first month of the year, your monthly cogs would be ,000 ( * 1,000).

However, as your business grows and demand for your product increases, greater demand for your computers necessitates more supply. So in the third month of the year, your computer sales increase to 4,000. This would bring your COGs 0,000 ( * 4,000).

With that in mind, it’s important to note that COGs are separate from other expenses. It is strictly and by definition only relates to costs incurred in making your product and/or service sold and earning revenue. Your business has other expenses that are incurred in the course of running and growing your business, such as sales and marketing, general and administrative costs, and the like. These operating expenses (abbreviated as OpEX) do not directly impact your production capabilities.

The direct impact your cogs have on your revenue is why it directly passes revenue on the P&L statement.

The importance of cogs

COGs are an important part of your business for several reasons. One of them is what we mentioned in the previous section, the relationship between COGs and revenue.

How little or how little your cogs are, determines another key metric: your gross profit and gross margin.

A company’s gross profit is, in short, the measure of how much revenue is left after deducting the full cost of making and selling your products and/or services. It is used as a profitability and measure of productivity. Gross margin, in turn, is gross profit expressed as a percentage of total revenue.

Gross Profit: Total Revenue – Cost of Goods Sold

Gross Margin: (Total Revenue – Cost of Goods Sold) / Total Revenue

Generally, we tend to focus a lot on revenue – naturally, because it’s the lifeblood of your business! But, COGs are the flip side of your earnings, and as such are also very important to monitor and understand.

The more it costs to produce a product and/or service, the lower the gross profit and gross margin will be. Conversely, the less it costs to produce a product and/or service, the higher a gross profit and gross margin will be.

What does that mean? In this latter scenario, because you used less money to produce your product/service, you retained more revenue and therefore have more money to spend as you wish! The possibilities abound: you can invest more in research and development, hire more people, pay off more of your debt, the list goes on.

Higher retained revenues equal greater opportunities, and that is why companies are always looking for ways to minimize production costs.

Let’s illustrate with an example.

Shiny Things, LLC earns ,000 in total monthly revenue from the sale of their merchandise. However, their monthly cogs are ,000, which means:

Their gross profit is ,000 (,000 – ,000)

And their gross margin is 20% ((,000 – ,000) / ,000)

So that means shiny things only keep 20% of his monthly income. That remaining ,000 is what he left to spend on operating expenses such as marketing and advertising; payroll and wages; Interest (if he has debts); Research and development; and, any other Opex.

So naturally, the higher the gross profit/gross margin, the better for your business. If shiny things found a way to minimize its inner workings to say, half the cost – so, ,000 versus ,000 – let’s take a look at what that would look like.

Assuming their earnings per month are still at ,000:

So you can see how the financial scenario of Advantage B confers brilliant things.

Therefore, it is very important to reduce your company’s COGs, without compromising the production quantity.

Now – how to do this?

How to manage your cogs

So if COGs increase naturally as your business grows, how can COGs be decreased? Doesn’t that go against the tide of productivity and expansion?

Not necessarily. Keep in mind that when we talk about managing or reducing the cogs, what we mean is how to produce your product at the same quantity (or more), but for less cost. Instead of spending ,000 a month, we want to spend ,000. How can this be done?

Here are a few tips.

1. Negotiate (or renegotiate) with suppliers

One of the first places to look when considering how to cut your cogs is at your current suppliers. They are, after all, the people who provide you with the raw materials with which you create your product/service. This is true whether you are a manufacturer, a retailer, or even a software company – someone, somewhere provides you with materials, supplies, or services.

If you are able to negotiate or reconstitute your price contracts with them, this will be a direct and significant way to reduce your cogs.

The crux of this is the status, history and friendship you have with your vendors. If you have a strong, kind, and on-time relationship (regarding payment) with your suppliers, the possibility of renigotiation is much better.

If your relationship is new, it may take some time to get to the point where negotiation is on the table.

2. Explore new suppliers

That said, understand that no business is obligated to use one or a set of vendors. Unless you’re working with a vendor that operates in a monopoly, one of the best ways to find lower cost of production is to scout competitors. Especially if your business is growing, this is good exercise.

The more your business grows and the more long-term plans you make up, the more companies will be interested in working with you as a supplier because you represent long-term value. Whether in the form of buying raw materials or buying existing products for retail/resale, every business is interested in the long-term image.

However, keep in mind that what makes a good supplier is not just who is the cheapest. It’s also about your long-term image, and maintaining quality is worth more than saving a few extra bucks on your cogs.

3. Streamline and eliminate unnecessary expenses

It’s worth taking a look at your expense accounts and rationalizing costs that aren’t totally necessary for your business. Cutting costs is never a popular exercise, but ditch the pain points, such as server maintenance costs for non-routine or unnecessary files, or expensive features that aren’t used (such as expensive newsletters or an analysis), can free up money, which makes a cumulative difference.

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