Why You Need to Understand Your COGS

The world of today is driven by data and numbers. The more digits you can pin down to reflect your business’s operations, the better you will be able to highlight issues and identify savings opportunities. The costs your business faces are among the most critical of these numbers.

In this article, we’ll take you through a major component of your company’s expenses: the Cost of Goods Sold.

What Is the Cost of Goods Sold?

From labor payments to raw material expenses, businesses incur various costs when they attempt to sell products. COGS is an accounting term for such costs.

In general, the Cost of Goods Sold – COGS – is the cost businesses face when selling their products, and it is based on inventory valuation. This is the lowest cost for which a company can sell its goods without making a loss. Mathematically, adding your Initial Inventory + Purchases - Ending Inventory gives you the Cost of Goods Sold.

Note here that costs that are not associated with specific items are not included in the calculation. For example, you will add in the cost of packaging, not the storage rent or the price of a new machine.

COGS Accounting Methods

If your product sits in inventory for a long time, you can not quote its cost to be the same as the exact number you got it for, courtesy of inflation and currency depreciation. Companies mainly use the three inventory costing methods to monitor the inventory level sold per a given time period. These include:

1. First In, First Out (FIFO): FIFO assumes that the goods a company procures or produces first are sold first. As prices increase over time, a company using the FIFO approach essentially sells its cheapest goods first. This keeps their COGS low as compared to dealing in newer goods that have higher costs associated with them.

2. Last in, Last Out (LIFO): In stark contrast to FIFO, the LIFO method assumes that the goods manufactured latest are sold first. A company maintaining its reports through LIFO maintains an inventory full of older goods that reflect low costs, and this, in essence, can let you reduce the amount you pay in corporate taxes.

Though reduced tax liability sounds tempting, beware, for LIFO is complicated and, in many cases, will not paint the right picture of costs for you to analyze.

3. The Average Cost Method: The Average Cost Method uses the average costs of all goods in inventory, overlooking the purchase dates entirely. This protects the COGS from extreme peaks and dips in purchasing costs and price fluctuations.

1. How Will Our Operating Expenses and One-Time Costs Play Out?

You need to spend money to keep your business running; forecasting these recurring operational expenses and overheads is crucial for budgeting. These can include:

• Premise costs, like rent and mortgage

• Machinery rent and depreciation

• Utility costs

• Transport expenses and vehicle depreciation

• Legal expenses

• Taxes

• Insurance Premiums

• Sales Commissions

• Loan repayment and interests

• Staff wages and benefits

• Marketing, advertisements, and promotional expenses

Go through your past fiscal year’s fixed and operational costs and identify any coming changes. For instance, if you’re building a new office, your utility bills will reflect an increase, and you will incur one-time costs to buy necessary equipment, like computers.

If you’re going through growth, determine the human resources you’ll have to enlist and estimate the cost of procuring them. Include training costs, estimated salaries, bonuses, compensations, and potential wage increases. In this way, break down all your operational and fixed costs and assess each category individually to create a detailed budget.

2. How Will Our Next Year’s Vendor Contracts Look Like?

Assess all your vendors individually for whether you will continue with their services or not. For the tier one suppliers you can not proceed without, look through your past fiscal year for your volume of purchases and unit costs they have charged you. Evaluate your sales goals and decide if you need to procure a more significant number of goods and services this time around.

Initiate discussions about contract renewals and amendments within your team per your vendor performances and past year’s spend. Also, enquire about your suppliers’ projections and whether they foresee any price or market situation changes that can affect the charges you’ll incur. In the situation that they predict cost increases, your budget must reflect it.

3. What are Our Company’s Income Sources and Goals?

Consider all the revenue streams you’re anticipating building, the type and number of clients you’re expecting to service, and what new vendors you’re hoping to enlist. For instance, if you intend on diversifying your production or expanding your operations onto a new geographical area, you can forecast more revenue and more expenses.

Oversight and Review

Budget creation needs control layers to ensure its reasonability. You need a controller or CFO to review each department’s budget and ensure it’s aligned with the expected revenue generation in the year to come.

It’s equally essential to conduct a forecasted vs. reality analysis after a set time period as you proceed with the year to ensure that you’re adhering to the budget and have oversight of your cash flow. Consider your income and analyze the reasons for shortfalls or high turnovers. Do the same with your expenditure for fixed and variable costs and determine if changes in them are causing your turnover to vary. Keep an eye on your cash burn rate and see if it fits your projections.

Do Businesses Really Need a Budget?

If you’re a smaller business, you may wonder whether budget creation is necessary or not. We’ll strongly argue that it is.

A budget lets you efficiently plan your spending, identifies where your resources are going, and consequently enables you to evaluate if you can continue operating and handle emergencies, given your cash flow. Making one per your company’s goals will let you know on time whether you need to arrange for funding or not. Budgets also allow you to ensure you’re getting decent profit margins so you can rectify any shortcomings on time. And after you have established a budget, it will act as a standard against which you can compare your performance.

Should You Outsource Your Budget Creation?

If your company is not ready for a full in-house finance team due to a smaller size or an uncertain financial situation, you should invest in an outsourced advisory. Outsourcing lets you pick and choose the type and depth of services you need depending on where your firm stands. This makes it cost-efficient compared to paying full-time hires you may not need 24/7 yet. Given the necessity of budgeting, we strongly advise having someoneelse do it instead of overlooking it due to the lack of expertise or finances.

Let Trusteer Help You

An experienced advisory finance and consulting team like ours can help you with creating and assessing a budget. This includes taking your monthly financial statements and analyzing them against your budget to determine whether you’re in line with it and highlighting the consequences they will have for your business in the near future.

We’re flexible in allowing our clients customization per their needs, and that helps them manage their spending optimally. Our experts have helped countless firms before, during, and even after those organizations hired a full in-house finance and accounting team.

Contact us today, and let us handle the number game for you.