Understanding Expenses: Cost of Goods Sold and Cost of Sales
As a small business owner, it's important to understand the financial terms and jargon used in accounting to make informed decisions that can impact the success of your business. Two commonly used terms in accounting are "cost of goods sold" and "cost of sales." While these terms are mostly interchangeable, they a few differences that can be confusing, affecting your financial statements and decision-making processes.
What is Cost of Goods Sold?
Cost of goods sold or “COGS” is the total direct cost of producing or purchasing the goods that a company sells. This is normally the cost of raw materials, labor, and overhead expenses directly associated with producing the goods. In simple terms, COGS is the cost of the product before it is sold. COGS is shown on a company's income statement as a line item just below the revenue line.
For example, the COGS for a restaurant would include:
Food cost
Supplies used to cook the food
Supplies used to package and serve the food
Supplies used to ship the food
The salary of the kitchen staff that cooks the food
Utilities that enable the kitchen to make food
What is Cost of Sales?
Similar to COGS, Cost of Sales is the total direct cost of selling a product, but would could include some expenses that are only direct costs because of the specific industry in which the business operates. This can include sales commissions, advertising expenses, and shipping costs. You would more commonly use Cost of Sales for service businesses like lawyers, accountants, and ad agencies, where third-party fees are directly related to the sale.
Using an law firm for example, most of the direct costs would be lawyer salaries, leading to the importance of tracking “billable hours”, but depending on the type of legal practice could also include something like court filing fees, or registration fees that must be paid in order to complete the sale.
Why is Tracking COGS Important?
COGS and cost of sales are considered "above the line" expenses because they are subtracted from revenue to calculate the gross profit. Gross profit is the difference between revenue and the cost of goods sold or cost of sales. This is an important financial metric because it shows how much money a company is making from selling its products or services before deducting other expenses such as general operating costs, interest, and taxes.
What is Above the Line?
"Above the line" refers to the line in a company's income statement (ie. Profit and Loss, or P&L) that separates revenue from operating expenses (ie. OPEX).
Example Income Statement Identifying Dividing Line between COGS and OPEX
On the other hand, ”below the line" expenses are deducted from gross profit to arrive at net income. Above the line expenses are considered more important than below the line because they directly impact a company's ability to generate revenue, whereas below the line are operating expenses that are discretionary relative to the actual sale.
Tips for Small Business Owners to Differentiate Between Above the Line and Below the Line Expenses:
Keep accurate records
To differentiate between above the line and below the line expenses, it's important to keep accurate records of all expenses incurred by your business. Bookkeeping software can help you keep track and sort these expenses efficiently.
Categorize expenses correctly
Ensure that expenses are categorized correctly when recording them in your financial statements. This will help you identify which expenses are above the line and which are below the line.
Understand the impact of expenses
Take the time to understand how each expense affects your business's financial statements. This will help you make the right decisions about which expenses to cut or reduce.
Seek professional advice
Consider working with a professional bookkeeper or accountant to help you understand your financial statements and make informed decisions about your business.
How Separating Above and Below the Line Expenses Can Help with Cash Flow Decisions
Separating above the line and below the line expenses can help small business owners make better cash flow decisions. By focusing on above the line expenses, business owners can identify areas where they can increase revenue or reduce costs to improve their gross profit margins. This can help them make informed decisions about which expenses to prioritize and which to cut or reduce. By focusing on improving gross profit margins, small business owners can increase their cash flow and improve their financial health over time.
In conclusion, understanding the difference between cost of goods sold and cost of sales is important for small business owners. By differentiating between above the line and below the line expenses and focusing on improving gross profit margins, small business owners can make informed decisions about their business and improve their financial health over time. By keeping accurate records, categorizing expenses correctly, understanding the impact of expenses, and seeking professional advice, small business owners can ensure that they are making informed decisions that will benefit their business in the long run. Ultimately, by separating above the line and below the line expenses, small business owners can optimize their cash flow and achieve greater success.
