Ever struggle to understand Cost of Goods Sold? What is it? What isn’t it? Well you are not alone. We have found that Cost of Goods Sold tends to be one of the single most difficult sections for entrepreneurs creating their financial projections with ProjectionHub. So, we have created a video that attempts to walk you through the process of forecasting your cost of goods sold. If you have more specific questions, please don’t hesitate to contact us.
By Adam Hoeksema
Cost of Goods Sold, also known as COGS, is one of the most difficult, yet important elements of your business to understand. The basic definition of cost of goods sold is as follows:
“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.”
Today, I want to focus on 3 simple ways you can reduce your COGS which will translate directly to your bottom line.
1. Buy in Larger Quantities – When you buy in larger quantities you will often be able to take advantage of quantity discounts. You may also benefit from shipping discounts. It is much, much cheaper per unit to ship a truckload full of product than it is to ship a pallet full of product. This is a no brainer, but some entrepreneurs never even ask their supplier what sort of discounts they could benefit from if they were to purchase in larger quantities.
2. Automate – In a world where we need jobs, this might not be a popular answer with the governments of the world, but for each job you can replace with a machine, your cost of goods sold will decrease drastically. Machines don’t form unions, they don’t go on strike, they don’t need health insurance, and they get to work on time. If you don’t automate in the areas that you can, your competitors will, and you will ultimately go out of business because you simply won’t be able to compete with their prices.
3. Lock in Long Term Pricing for Raw Materials – This is a bit of a risk, but for some companies this strategy really pays off. For example, Southwest Airlines locked in pricing for jet fuel in a long term contract right before fuel prices spiked exponentially. This gave Southwest a huge advantage over their competitors. On the other hand, what if Southwest locked in the prices right before the price of fuel crashed? Their COGS would have been awful compared to the industry. If you think the price of a raw material that is core to your business is poised to increase, you may consider entering into a long term agreement with a supplier.
If you would like to play around with some numbers and project how your cost of goods sold would be impacted by various scenarios, then create a quick set of financial projections with ProjectionHub and we will walk you through the process of projecting cost of goods sold. Good luck!
What Is The Cost Of Goods Sold For A Service Business?
When it comes to the cost of goods sold for services, the cost of goods sold for a service business doesn’t quite make sense. If you want to be precise, Cost of Goods (COGS) is only used for product based businesses.
So what if you operate an IT service company, what is your COGS? What if you develop and sell software? How do you determine the cost of goods sold for a service business?
Rather than using the term cost of goods sold, it would be best to use a similar term — Cost of Revenue.
What is Cost of Revenue for Service Based Businesses
Now I want to dive deep into exactly what Cost of Revenue is and what it is not. I also want to help you determine your cost of revenue for a service company on a per unit basis.
“The total cost of manufacturing and delivering a product or service. Cost of revenue information is found in a company’s income statement, and is designed to represent the direct costs associated with the goods and services the company provides. Indirect costs, such as salaries, are not included.”
What Is Included In Cost of Revenue For A Service Company
Raw Materials – Service based businesses don’t have “raw materials” but if you were a product based business, you would include all raw materials used to produce the product in cost of revenue.
Direct Labor – Direct labor should be included in the cost of revenue for a service company. Let’s say you own a junk removal business, and you get a job to clean up an old building. It will be a 3 hour job for your team of 3 guys. Each guy is paid $10 per hour. Your employees wages is considered cost of revenue, so in this scenario you would have $90 in direct labor costs that would be included in your cost of revenue.
Shipping Costs – Let’s say you own an accounting firm that audits companies. At the end of the audit you print your report and mail copies to each member of the client’s board of directors. If you end up paying $100 to ship your report to the board, that $100 should be included in cost of revenue because it is a necessary expense that you incur as part of your service.
Sales Commissions – Sales commissions are another common expense that should be included in the cost of revenue for a service company. You only incur sales commission expenses when you generate revenue through a sale of your product or service; therefore, sales commissions should be included in your cost of revenue.
A common rule of thumb when determining what is cost of revenue and what is not, is to simply ask yourself, “Would I incur this expense if I did not make a sale today?”
What Is Not Included In Cost Of Revenue For A Service Company
Now I will go through a list of expenses that you would incur whether or not you sold a product or service. These expenses should not be included in the cost of revenue for a service company.
Salaries – Employee salaries are not directly tied to revenue, in other words, your employees are paid the same salary each month whether they sell more or less goods and services.
Rent – Your rent expense is another overhead cost that is not included in cost of revenue.
Phone Service – The phone bill will arrive each month whether you sell 100 widgets or 1,000,000 widgets; therefore, it is not to be considered part of your cost of revenue.
Utilities – Now this might be up for debate because your utilities might go up or down based heavily upon your sales volume, but even if you did not sell any product or service next week wouldn’t you still turn the lights on? Wouldn’t you still heat or call your office building? In general your utilities are not considered as past of Cost of Goods Sold or Cost of Revenue.
Cost of Revenue Per Unit
Once you have determined which expenses to include in the cost of revenue for a service company, you should come up with your cost of revenue per unit. Cost of Goods Sold per unit and Cost of Revenue per unit is the model we use with our ProjectionHub application.
Essentially you need to break down each expense that your cost of revenue is composed of into a unit cost. For example:
Let’s say you own a tree service company. Let’s go through the cost of revenue for one day-long tree service job. Your cost of revenue might look like this:
Sales Commission – You might have a sales representative who secured the job for you, who you will need to pay a commission. Let’s assume you give a 15% sales commission.
Fuel Costs – You have to drive out to the job site with a fleet of 3 vehicles and equipment. This is an expense that you would only incur if you got the job; therefore, it should be included in cost of revenue. The job site is 50 miles away, so each vehicle will drive a 100 mile round trip. So 300 miles at .50 cents a mile is $150.
Direct Labor – Lastly, you will have direct labor costs. Let’s assume it takes a team of 5 to complete the job in 8 hours. You pay them each $10 per hour.
Now that you have identified your 3 items that make up cost of revenue, you need to bring this down to cost of revenue per unit. The unit that most service businesses use is hours. Let’s say you charge the client $300 per hour. Your cost per hour would look something like this:
5 workers x $10 = $50 per hour
15% of $2,400 job = 360 sales commission / 8 hours = $45 per hour
$150 / 8 hours = $18.75 per hour
Add that together and you get $113.75 per hour as your cost of revenue.
$300 – $113.75 = $186.25 is your gross profit.
There you have it. That is how you calculate both the cost of revenue for a service company, the cost of goods for a service company, and gross profit for a service based business. Once you’ve determined your COGS, then you can figure out how to reduce your cost of goods sold.
Use our auto body shop financial template or medical office financial projections template if you are looking for a full financial projection template for a services based business. You can also use our Professional Services template or check out our excel financial projection template library which may prove to be useful for your own project.