The direct costs attributable to the production of the goods sold by a company. This amount includes the cost of the materials used in creating the good along with the direct labor costs used to produce the good. It excludes indirect expenses such as distribution costs and sales force costs. COGS appears on the income statement and can be deducted from revenue to calculate a company's gross margin.Quite often, this simple definition is not enough for people to understand the true impact, of selling a product that requires the purchase of supplies, on the bottom line or on a company's cash flow. By this definition, ONLY those items that can be directly attributed to the production of an item are included. This means that production inventory is the key to this part of the puzzle. The labor is often mush larger but more easily attributed. Few recognize that COGS is only a piece not the whole puzzle.
One mistake often made is to reason that a product, which is sold for more than the cost of producing it, will always be cash flow positive. This is not usually true for two reasons:
- You have to buy the supplies before you sell the product (except Toyota and Dell)
- You have to pay to assemble, test, and package the product before shipping
- You do not get paid for 30, 60, or even 90 days AFTER you ship product.
- The bank may hold the payment for a few days before you can use the funds
A good financial model can help predict when there will be cash flow issues that result from selling more than you can afford to make. It is not necessary that every small company have a CFO. A good CPA can help with this issue. Once a company has been in operation for some time, they often have a sense of this issue, even if they don't directly identify it.
What do you do if your business sells services?
How do you account for the cost directly in each service?
There are materials: hours spent, paper, travel, and meals, where are they recovered?
What about the cost of developing the service?
How are improvements, replacements, and innovation funded?
How do you pay for the training, the R&D for software, and the advertising?
These later items are all expenses. Quite often in an early-stage operation, it is hard to predict the amount that will be spent per sale. This is one reason that investors always double the time and the cost of everything in a start-up.
As I work on business plans, for service or physical product companies, some of the questions I ask are about the Sales Funnel. Do they know the conversion rate for each step? Do they know how many hours of a salesperson's time will be required, per call, at each stage or step? Do they understand how that has to be factored in to get a better idea of how cash will flow in reality? Most do not.
My limited blogging experience has shown me that brief, but daily posts are better than infrequent lengthy articles. With that in mind, I will continue with the Sales Funnel tomorrow. If you can't wait - there are many great places on the Internet to find examples (like this one at Mind Tools) and even a pre-programmed spreadsheet to play with from the Australian website for PDM - Performance Directed Management.
In the meantime: What have you learned about COGS that you feel was not obvious at the outset?
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