No, this is not an episode of the Jetsons. We are not discussing Spracely Sprockets or Cogswell Cogs. This week we are starting to dive down into the difference between Revenue and Profit. Since we have discussed Revenue in a previous post, then we need to start talking about the costs involved in making product or Cost Of Goods Sold. This is what COGS stands for and it is an acronym that relates to the direct costs of making your product or service.
Couple of notes before we dive in. If you are a Sole Proprietor and deliver a Professional Service (like say you are a Business Coach), then COGS is not a very useful thing to discuss in their own business. Everybody else should be greatly concerned with COGS. The second thing is there is some minor parts of variability in the way these costs are accounted for per company. As long as you follow the general guidelines, your particular variant will be fine. The biggest thing is to be consistent. In the future, we will be talking about other costs and I hope to be clear on why we separate them.
COGS is all about variable costs. If you sell something that has an intrinsic cost to make, then the number that you sell has a direct impact on the costs in your business. The fewer that you sell, then the lower your cost is of making your product. Of course, the lower your revenue as well. So, what comprises COGS? The materials and labor directly associated with making your product available to sell. There are a few things to think about when we talk about costs.
Most larger companies work with something called “Standard Cost”. That means they don’t calculate the actual cost of a specific item. They have a standard that they use and then track variance from that standard. The standard is set annually in most cases. Now why do that? Suppose you make cupcakes (in a nod to the E-myth). Let’s say there is a sale on Flour. That means your cupcakes are less expensive to make, since your ingredients are cheaper. But you might also run out if you have a large order. To meet the order, you go to a local grocery store and that costs more than your normal supplier. Keeping track of each cupcake’s cost at that point seems like a lot of work. To simplify this, companies simply track their variance in purchasing and deal with it as an overall average.
Second, many small business owners are directly part of the production. How do you account for your own labor? Well, the best way is to “pay” yourself like you were an employee that you would assign to your work. Don’t forget when you do that you need to use “Burdened” cost. That means you not only have to include salary but the total cost of employing the person (Workman’s Compensation, Benefits, etc.).
Now, why is this important? Once you have all your COGS, you subtract that number from your Revenue. You end up with a number called “Gross Margin”. This is not your full profit, but the money that you have from the sale of the item. Most companies state this as a percentage (“We have a 45% Gross Margin). This means that this is the Percentage of Revenue that you can use to pay for everything else that you do (You have 45% of your Revenue left after you have made your product).
This percentage varies in different industries and tends to be similar for all companies that are in similar businesses. There are companies that can provide standard information for what your Gross Margin percentage should be based upon what other’s are getting.
Next week its all about OPEX!
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