Cost of goods sold (COGS) shapes any business's profitability. It’s also essential for developing pricing strategies, accurate business reporting, and strategic decision-making. Read on to learn about the term and the concepts behind it.
What is COGS?
Cost of goods sold (COGS) refers to the direct production cost of goods sold by a business. This includes both raw materials and direct labor costs. For digital products, “raw materials” can include finite, spendable resources - like bandwidth bought from a third party.
COGS does not include indirect expenses like distribution and sales force costs. These are known as operational expenses or overheads - two similar but different terms - and calculated separately.
Why is COGS Important?
COGS is a vital metric as it directly impacts the profitability of a business. By understanding and monitoring COGS, businesses can:
- Accurately determine product pricing. By understanding the production costs of a product, it’s easier to set a fair and profitable selling price.
- Calculate gross profit. Gross profit is directly linked to the financial health of a business. It’s a figure business owners need an accurate view of at all times.
- Make more informed decisions. Pricing strategies and inventory management are all linked to the cost of goods sold. Understanding COGS means management teams can make educated decisions that will benefit the business over the long term.
How to Calculate COGS
Fundamentally, COGS can be calculated using the following formula:
{COGS} = {Starting Inventory} + {Purchases During That Period} - {Remaining Inventory}
For example, let's take a simple business: a fruit retailer. If the business starts with $5,000 worth of inventory, makes $2,000 in purchases, and ends with $3,000 worth of inventory, the COGS would be $4,000. The fruit sold are - ostensibly - worth $4,000.
In real life, COGS is often complicated. Even a simple fruit-selling business will have some fruit spoil during transportation, for example. Factors like these change COGS, making it tricky to calculate. The situation is even more complicated for digital products.
COGS for SaaS Vendors
For Software as a Service (SaaS) vendors, COGS calculations are different from traditional businesses. The big difference is, SaaS vendors don't deal with physical inventory, but delivering a service still results in direct costs. These might include:
- Server and hosting costs
- Third-party service and integration fees
- Cost of supporting and maintaining software
- Licensing fees
For a SaaS company to calculate COGS, it would need to add up these direct costs over a given period.
It is important for SaaS vendors to calculate COGS accurately and strategically. Underestimating COGS can boost taxes a great deal - so to maximize profit, SaaS companies need to assess them accurately.
The Role of COGS in Tax Payments
Understanding COGS is also crucial for tax purposes. Here's why:
- Deductible Expense. COGS can be deducted from a business's revenue, which reduces taxable income. A lower taxable income means a lower tax liability.
- Inventory Valuation. COGS can be used to determine the value of remaining inventory, which can impact reported assets. Consequently, this would also affect the financial health of a company.
- Financial Reporting. Accurate reporting of COGS is essential for compliance with financial regulations and standards. Failure to do so could result in penalty fees.
