What the Heck is Cost of Goods Sold?

What the Heck is Cost of Goods Sold?

by | Jan 4, 2025 | Blog

I swear that the Cost of Goods Sold (COGS) is not as hard as you would imagine.  It’s frustrating because you’re trying to figure out where to put your expenses, is it Overhead, is it COGS, what the heck? I know you’ve been trying to search through google and the articles are confusing.

And they make you do MATH.

Ok, you may have to do a little math, but I promise it won’t be as bad as you think.  And with a spreadsheet, it will be super simple.

But before we delve into the math let’s figure out what exactly it means.

What is Cost of Goods Sold (COGS)

I think Investopedia was put on this earth just for me.  They always have simple, easy explanations for even the most complicated topics.  If you’ve never heard of them, you should go, and bookmark the site right now.

Let’s take the definition and break it down.

Cost of goods sold (COGS) refers to the direct costs attributable to the production of the goods sold in 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.

The Accounting Formula for COGS goes something like this….

COGS = Beginning Inventory + Purchases during the period – Ending Inventory

So, what does that gobbly gook mean for you?  To make it make sense to you need to know what type of business you have. Are you a retailer with a brick-and-mortar store, a wholesaler that sells to retailers, or do you have a service-based business?

Since most of COGS has to do with inventory, we’re going to start with an example of a company that produces coffee tables.

Let’s say you are a wholesale producer of a coffee table.  You buy raw materials like lumber and nails. and build a coffee table and sell it to a retailer.  Your cost of goods would look a little like this…..

At the beginning of the Month, this is the raw materials you have on hand and what you bought it for.

Beginning Inventory

4 Pieces of Cedar Wood for $100.00

1 Box 50 of Nails $10.00

During the month you bought this.

1 Box of Nails for $10.00

5 Pieces of Cedarwood

Let’s plug in the numbers

May Beginning Inventory
Inventory Name
Qty
Unit Price
Inventory Value
Cedar 4 $25 $100
Nails 50 $.20 $10
Total Inventory $110

 

End of Month Inventory
Inventory Name
Qty
Unit Price
Inventory Value
Nails 75 $.20 $15
Cedar 2 $25 $50
  Total Inventory $75

Your COGS for all your products is $95.00.

Now let’s say you want to know how much inventory you used for each coffee table.  (Not an exact science unless you are keeping track.  Just the number of coffee tables you sold by the COGS for May

For example

You sold 5 coffee tables

$75.00/5 = $15

For every coffee table, your cost of goods sold is $19.00.  Enter that into the profit tracker and you’ll easily be able to see how your costs are keeping up.

This example is just for raw materials and doesn’t consider freight or labor costs.  Now if you want to add the freight cost you can do it by either a single line item or you can add it to the price per unit.

What do I mean by freight you ask….

I’m talking about what the supplier charges you to ship the raw materials to you.  Generally, this is a line item on the bill.  For a longer explanation check out this article on Freight charges.

Make sure that when you enter the line item in your expenses as it is a COGS. Category.

Now that we understand what COGS is when producing a product what other charges besides raw inventory and freight should be considered?

What You Need to Know About Labor and COGS

There are some labor costs that may be tied directly to the production of your product.  Let’s say that again with an example.

Let’s say your company not only builds coffee tables but you have a factory and in that factory there are employees.  Inside your factory you have

1 Office Manager

2 Factory Workers

The factory workers actually build the product so their wages are considered COGS as well.  However, the Office Manager is considered an overhead expense (hey s/he might be awesome but for accounting purposes, they are overhead).

Let’s take a second example of a service-based business.  Heck let’s use my accounting business (just for fun).

We employ

1 Administrative Assistant

1 Bookkeeper

The bookkeeper only works on my clients’ business so s/he wages would be considered COGS. But the Administrative Assistant is considered overhead.

Now if I wanted to I could break this down even further and if we keep track of the Bookkeeper’s hours we can use the portion of the time that is spent on clients’ work as COGS and the remainder would be under overhead expenses.  This way only the time worked would be distributed to COGS and other times like education and training would be considered overhead.

Still unclear?  No worries if you want more information on Direct Labor check out our Block post Do You Know What Your Direct Labor is Costing You?

Other COGS Not Normally Counted

Let’s talk shipping.  If you own an e-commerce store and ship products to your customer, then you may be able to track the cost to ship to your COGS.  Let’s use our coffee table example to go a bit further.

Our company sells coffee tables in a Shopify store.  We decided that we would make shipping free to our customers.  So whatever the shipping costs to our customer we can add this to our COGS.  I would normally just add a line item on my expenses for each sale and then Average them for the month and divide them by the number of sales.  That way you can forecast approximately how much shipping will be for every unit sold.

Shipping = Total Shipping Costs/Total Sales

Now if we charge the shipping costs to the customer this would be basically a 0 line item or what we in accounting like to call a Pass-Through account which means we keep track but the line item should always be 0.

Now if we charge shipping costs to the client above the actual costs to ship the product (also known as a Markup) That actually becomes a product in itself and you’ll want to keep track of it.

What to do When Your Supplier Raises Your Prices

Oh no your supplier raised their prices now how do you figure your cost?  The above example when we were talking about raw materials is considered the AVERAGE Cost but we have a couple of others.

Let’s use our above example

Before the supplier raised their prices the cost of Cedar Lumber was $25.00

After the supplier raised their price the cost of Cedar was now $50.00 we bought 4 more.

Before raised their price  4 X25 = $100.00

After the supplier raised their prices the 4 X 50 = 200.00

Andrea's Tip

When you’re selecting a cost method, you’ll need to make your choice based on guidelines provided by the IRS.

Average Cost Method

The average cost is the most straightforward.  You’d look at all the inventory purchased and figure out the average cost for the wood.  Total up your inventory and divide by the number of units and you have the average cost.

300/8 = $37.50 unit price for Cedar

First In, First Out (FIFO)

FIFO assumes that the coffee table that you built uses the first order of lumber before it will use the second.  Under this rule, you use the last price that the supplier charged you which means your per-unit cost would be $50.00.

FIFO is used during times of rising prices because costs are recorded as lower and income is then recorded as higher.

Last In, First Out (LIFO)

With LIFO we assume that the first pieces of lumber you use are the last pieces of lumber that you purchase.  Since you used up that you used 2 units at $50.00 each and the next 2 units would be at $25.00.

LIFO is used mainly during times when tax rates are high because costs assigned will be higher and income will be lower (which gives you a bigger break on your taxes.).

Notes:  It can be difficult to select a cost method, and there are certain guidelines that the IRS provides that you used 2 units at $50.00 each and the next 2 units would be at $25.00.

Andrea's Tip

In the US if you want to change to LIFO you’ll need to fill out IRS Form 970.

FAQs on COGS

How do I determine if a cost should be included in cost of goods sold?

Ask yourself if the cost would exist if the company didn’t sell anything for a period of 3 months?  If the answer is Yes it’s most likely overhead.  If the Answer is NO then you have found your first COGS.

 

Should Service Based business use COGS?

Generally speaking service based business do not need to track COGS.  Though as with everything financial there are exceptions.  If your company keeps inventory for use to replace parts like plumbing company, or roofing company then using COGS will help your business.  But if your a lawyer’s office that uses office supplies in the course of doing work you may just want to place this under office expenses.

Can’t I just keep track of it as an Expense instead of Cost of goods sold?

Keeping track of your COGS is important for tax purposes and managing your financies. 

 1.  Most states will tax inventory that is left over at the end of the year.

2.  It’s a reduction in your taxable income vs. a deduction of expenses can help reduce your tax burden in some cases.

3. Helps in determining the following items.

      • Calculating Gross Profit
      • Calculating gross margin
      • Understanding production efficiency
      • Pricing your product so you make a profit.

Andrea's Tip

Don’t underestimate the importantce of tracking your expenses properly with a solid accounting.  It’s the easiest way to ensure that your business stays healthy and profitable.

Putting it All Together

We’ve covered a ton of information.  From defining what Cost of Goods Sold is to writing up examples of how it can be used for your business.  I hope that you’ve found the information useful.  I know that calculating COGS can be difficult but keeping track of your costs is one of the most important things a small business owner can do.  Just keep in mind that most accounting software will keep track of your COGS for you and of course, we can calculate that for you if you need some help.

As Always if you have questions or need a consultation you can always talk to us.

Cheers!

Andrea

The Art and Science of Pricing Your Product

The Art and Science of Pricing Your Product

by | Jan 2, 2025 | Blog

Ok, maybe it’s both.

No matter what you sell, the price you charge your customer or clients will have a direct effect on the success of your business.

The moment you make a mistake in pricing, you’re eating into your reputation or your profits.

Katharine Paine

The 4 Rules of Product Pricing

First, let’s talk about the  4 rules of product pricing.  (by the way, if I say product just assume from now on I’m talking about services 2.)

  • Pricing Rule 1: All Prices must cover the cost of producing the product or service, profits, and taxes.
  • Pricing Rule 2: You should review your prices and costs frequently
  • Pricing Rule 3: The most effective way to lower prices is to lower costs.
  • Pricing Rule 4: Review your competitors’ pricing frequently.

Before we start discussing how to figure out pricing we should look at the different types of Pricing Models.  That way we can easily figure out which one may work better for you.

 

4 Pricing Models That Will Help you Price Your Products

Understanding the different pricing models will help you figure out which ones will work for you and your business.

Cost Plus Pricing

The cost-plus pricing model is generally used by manufacturing.  Because they are producing physical products and selling them more at a wholesale cost.  With the cost-plus model, you want to make sure you capture the plus figure so that it covers ALL the overhead and can still generate a profit for you.  I love examples so check out the table below.

Cost of Material 50.00
Add the Cost of Labor 15.00
Add Your Overhead/Expenses 20.00
  Total Cost to Produce 85.00
Now Add Your (5%) Profit  (or whatever % you want to set aside) 4.25
Add In Your Pay (50%) This is what you will live on) 42.50
   The Minimum Price for this Product $131.75

Demand Pricing

Demand pricing is pricing that is a combination of volume and profit.  Generally, this means that the product is sold through various sources at different prices.  For example at a Walmart store or online through a discount retailer.  Your local brick-and-mortar store will probably pay more per product because they are unable to stock, and sell a large quantity of the product.  Which is why retailers charge high prices to customers.  Just remember that demand pricing can be very difficult to master and may not be the best place to start until you have a great understanding of your current market.

Markup Pricing

Markup pricing is used by wholesalers, and retailers to price the goods for retail suppliers to customers.  Markup is calculated by adding a set amount to the cost of a product.  For example, you buy a product for $100 and then add $40.00 to the price to sell it.  To find the percentage divide the cost by the amount you want to add on to the product.

$40/100=40%

This can be very confusing, for many small business owners because the markup is often confused with the gross margin.  But really all it really means is that you are adding the overhead expenses, profit, and your pay to how much you actually paid for the product from a wholesaler.  Don’t worry we’ll go over the Pricing Basics next so you can see how this will work for you.

 

Now on to the rules…..

Rule 1:  Products Must Cover Cost, Overhead and Profits

Now that you know the rules surrounding product pricing you need to figure out the costs involved in running your business.   If the price of your product doesn’t cover costs, you will eventually run out of money and you’ll exhaust your savings…. eventually, your business will die out.

Quit worrying that’s why you are here, isn’t it ……?

To price products, you’ll need to get familiar with pricing structures, especially the difference between margin and markup.  Remember every product must be priced to cover creation and business operation costs.  Things like a high overhead, insurance, inventory and sales, and discounts will affect the final price.  This brings us to Step 1.

Figure out your business costs and expenses

Do you have…

  • Property
  • Equipment
  • Loans
  • Inventory
  • Utilities
  • Employees (Wages, Salary, or Commissions

If you’re a business that also has material products you’ll want to add the following to your list.

  • Markdowns
  • Discounts
  • Returns

This is by no means an exhaustive list of potential expenses but it’s a great place to start.

Types of Expenses

Fixed Expenses.  No matter the volume of sales, fixed expenses must be met every month.  Fixed expenses include expenses like rent, utilities, membership, subscriptions, insurance, etc.

Variable expenses.  These are expenses that can fluctuate in price from month to month.  For example Marketing.  Marketing may change depending on the season, supplier inventory, and office supplies.

Cost of Goods Sold.  Every time I see a description of the cost of goods sold it can get very confusing.  I’m going to put a brief description here but I want you to review our article on Figuring out your Cost of goods in this article.  This will be more helpful and hopefully, explain it in a more clear and more concise manner. But for now…..

Cost of goods sold, also known as the cost of sales, refers to your cost to purchase products for resale or to your cost to manufacture products. Freight and delivery charges are customarily included in this figure. Accountants segregate the cost of goods on an operating statement because it provides a measure of gross-profit margin when compared with sales, an important yardstick for measuring the business’ profitability. Expressed as a percentage of total sales, the cost of goods varies from one type of business to another.

Normally, the cost of goods sold bears a close relationship to sales. It will fluctuate, however, if increases in the prices paid for merchandise cannot be offset by increases in sales prices, or if special bargain purchases increase profit margins. These situations seldom make a large percentage change in the relationship between the cost of goods sold and sales, making the cost of goods sold a semi-variable expense.

Rule 2:  Figure in Your Profit including Your Pay

Yes, you heard me right for every product or service you sell you need to figure out how much you want to pay yourself and place that as a part of the expenses.  If you never get paid, what for Pete’s sake is the point of doing any business at all?

Again, you heard me right for every product or service you sell you need to figure in your profit.  If you don’t know what your profit should follow the table below.

Andrea's Tip

If you are not making any money or just opened your doors follow the lowest profit in the table at 5%. You can always raise your prices once you’ve established your sales goals.

Competitive Pricing

Competitive pricing is usually set when there is already an established market price for a product or service.  For example, if all your competitors are charging $100.00 to, let’s say, clean your air conditioner, it may be difficult to charge $200.00.  If this is the case you may need to look at lowering your costs in order to make a greater profit.  If you still think that you can charge a higher price then you should look at the value that you are providing if you could add a warranty policy or awesome customer service.

If you use competitive pricing to set the fees for a service business, be aware that, unlike a situation in which several companies are selling essentially the same products, services vary widely from one firm to another. As a result, you can charge a higher fee for superior service and still be considered competitive within your market.

Rule 3:  The Most Effective Way to Lower Prices is to Lower Cost

Let’s say you make high-end desks for home offices.  Your competitors seem to be lowering the price of their products.  You want to review the costs associated with building your desks.  You’ve been religiously using the profit tracker or some other system that keeps track of your expenses and you realize that you are spending double what you used to on lumber.  Maybe you need to change your supplier?  Maybe you need to use a different type of wood.

Just for simplicity’s sake you go back to your supplier and say hey man we need to discuss and maybe renegotiate the price I’m paying for lumber.  The supplier says sure we can do that.

And with that one sentence, you can lower your prices because now your lumber is lower than it used to be.

Andrea's Tip

It’s a good idea to review your supplier contracts each quarter to see if there is room to negotiate.

Pricing takes time and a lot of research.  Most business owners use the “Set it and Forget” and then pray for the best.  But if you don’t review the numbers then most likely you will risk your profits and not know if there is a way to reduce costs or increase prices.

When should you review your prices?

  1. Each Month
  2. Each Quarter
  3. Annually
  4. You Introduce a New Product
  5. Your costs change
  6. Your competitors change their pricing
  7. Business seems to be slowing or Business is increasing (yeah great problem to have)

Putting it All Together

Whew, there you have it, how to price your products and services so you have plenty of cash in your business.  Make sure you follow the rules.

As Always if you have questions or need a consultation you can always talk to us.

 

Cheers!

Andrea

What is a Registered Agent?

What is a Registered Agent?

by | Jan 2, 2023 | Blog

You probably came across the reference to a Registered Agent while filling out the paperwork for your Limited Liability Company (LLC).  Now you’re wondering what is a Registered Agent? What is a registered office and what should I do now?   

Well, here at Simply Tax Compliant we’re trying to build a place where new business owners like you…get the answers to those questions. 

Let’s get down to the nitty gritty the legal definition… 

In United States business law, a registered agent (also known as a resident agent,¹ statutory agent,² or agent for service of process³) is a business or individual designated to receive service of process (SOP) when a business entity is a party in a legal action such as a lawsuit or summons. 

Wow, what a mouthful.  What it really boils down to is a person who can receive legal documents for your business.  See now wasn’t that easy. 

Basically, you, as a business owner, need to designate a person within your company to receive documents on your behalf.  Now when most people start their business they designate themselves.  That’s not always the case. 

What do you need to be a Registered Agent? 

In most states, the requirements for being a registered agent are pretty simple 

You MUST have a street address located in the state where the LLC is formed.  For example, if you have your LLC in Texas you can’t use a street address in Alabama. 

Your registered agent should be available at the address during normal business hours to receive any documents on behalf of your LLC.  Now, this doesn’t mean you are tied to your office.  But it’s nice to have a person who can receive documents on your behalf.  This is more important if you have more than one location.  You know like a headquarters. 

Your registered office can be an office or even a virtual address, it can be your home address or a friend or relative you just need to make sure that they can act as a service of process. 

A service of process is the place where you designate someone to accept legal documents on your behalf.  Don’t get mired down but the minutia. But they have to be able to accept things like complaints, summons, or subpoenas. 

Who Can be Your LLC’s Registered Agent? 

You have three options for designating your LLC’s Registered Agent. 

Option 1:  Most commonly you can act as your own LLC’s registered agent.  It is free which makes it the best option when you are on a low budget. 

Option 2:  You can use a family or relative with their name and address designated.  A great option if you have family members who you trust to take care of these matters for you. 

Option 3:  You can hire a commercial Registered Agent, generally for a fee.  Make sure you research the service beforehand as some will act as a virtual mailing address and some will not.   

How to Choose which option to use for a Registered Agent. 

Options  Criteria Notes
Use Option 1  Do you have a street address in the state where you are forming the LLC? 
Use Option 2 Do you have a family member or friend who you trust to receive legal papers? 
Use Option 3  If you are forming a second location in another state (aka a Foreign LLC) Then Option 3 is the best way to go.  If you don’t want to use your home address then a Registered Agent is the way to go. 

Definition of a Commercial Registered Agent 

A Commercial Registered Agent is a company that specializes in receiving Service of Process on behalf of businesses nationwide. They typically charge between $100-300 per year. 

Once hired, they will receive Service of Process on behalf of your LLC and then forward it to you by mail at any address you’d like. Most will also fax or email your documents if preferred. 

Putting it All Together

Now that you understand that you need to designate a registered agent you can pick which option will work best for your company.  Just remember that all 50 states have slightly different criteria so make sure you look up the rules for registered agents in your state.