Bespoke tailoring business Henry Herbert spends thousands of pounds each month buying top quality worsted wool from mills in the North of England, along with hand-made buttons and natural lining fabrics. These materials are then crafted into suits and other tailored clothing that can sell for over £5,000.
When spending this amount on materials it’s critical that Henry Herbert always tracks the Cost of Goods Sold, or COGS. This refers to the total cost in getting a product or service to customers. It can include raw materials and manufacturing, but also marketing, labour and distribution costs.
“We’re committed to using only the highest quality British fabrics and we pay a premium for those, but it means we need to track overall costs very carefully, because we can’t afford to reduce the quality of materials,” explains owner and director Alexander Dickinson. “We sit down with our accountants every month to track any movement in our costs.”
In this article we’ll explain what the cost of goods sold formula (COGS) is, how, like Dickinson, to use it to keep a close eye on your costs, and why this information is important to SMEs.
Why calculate the cost of goods sold?
It’s important for companies to use the COGS formula to understand what costs are associated with selling a product or service because this helps you to calculate overall profits and can be used to support strategic business decisions. “People understand that raw materials and labour are direct costs that should be included in COGS accounting, but businesses often overlook things like their own time taken to get a product out. If I charge £600 an hour for my time and spend a week developing a product, that could easily add another £25,000 in direct costs that need to be accounted for,” says Sara Tye, a business coach and growth consultant, and founder of communications agency Redhead PR.
At Henry Herbert, as costs for labour have increased, the company was able to reduce the cost for rent by opting not to keep expensive premises in London’s Saville Row. Instead, the company works remotely, using scooters to visit clients at work or at home to take measurements for bespoke suits. “We are very aware that labour costs have increased, which increases cost of goods sold, but we can’t pass that increase on to customers and remain competitive. We must be more creative about reducing other costs, notably premises and materials, by negotiating discounts with some of our suppliers,” says Dickinson.
Consumers and businesses alike are extremely price sensitive, so a good understanding of COGS means it’s easier to identify potential savings without passing on all cost increases to the customer. It may be that when calculating COGS you can see an opportunity to reduce pack sizes, fix input prices or even improve manufacturing efficiency, which are all alternatives we’re seeing businesses take to passing on price increases to customers.
What do you need to work out cost of goods sold?
Calculating the cost of goods sold involves tracking any expenses that a business incurs as a direct result of selling a product or service. This will typically include things like raw materials and manufacturing costs, but should also include things like labour, marketing of products and distribution costs.
To understand how to work out the cost of goods sold, you’ll probably need to work from your company’s accounting system.
The key pieces of information you’ll need are:
- Inventory: What is the total cost of your inventory during the most recent period?
- Expenses: What products and materials have been purchased during the period?
- Labour: How much has the company spent on labour, related to your product or service?
- Materials: What has the company spent on materials and supplies to make your product?
- Other expenses: What expenses in the business are related to your product/service. This should include shipping, overheads such as rent, hardware and software.
How to calculate cost of goods sold
COGS is the sum of direct expenses incurred by products and services that your business has sold. To calculate COGS, businesses need to consider all the direct costs associated with a product or service.
At Henry Herbert, the process of calculating COGS starts by taking the cost of current inventory and then adding all net costs related to producing and selling its products. “Of course, that starts with fabric, buttons and lining materials, but it also includes premises, the cost of freelancers who work on our designs and manufacturing, and marketing for the products,” explains Dickinson.
Cost of goods sold (COGS) formula
Before calculating COGS, it helps to understand two key terms: opening/beginning inventory and closing inventory. Opening inventory refers to the total value of items in stock, ready to be used or sold at the start of an accounting period.
Closing/ending inventory, therefore, refers to the total amount of stock left unused at the end of an accounting period.
The cost of goods formula is:
Opening inventory + net costs – closing inventory = cost of goods sold
Cost of goods sold calculation example
If we take the example of Henry Herbert, a cost of goods sold calculation might consider that the value of opening inventory is £100,000 and the company has incurred costs of £60,000 purchasing things such as materials, labour, equipment, shipping and marketing.
The formula for cost of goods calculation might therefore be:
Opening inventory (£100,000) + £60,000 (net costs) - £40,000 (closing inventory) = £120,000 (cost of goods sold)
Calculating cost of goods sold (COGS) ratio
Taking this process one step further, we can use the cost of goods sold ratio to understand how much of the revenue generated by your business is being used to pay for expenses that are directly related to supplying your product or service.
To calculate COGS ratio for your business use this formula:
COGS / net sales x 100 = cost of goods ratio
If your company has a COGS of £1 million, with net sales of £1.5 million, then the calculation would be:
(£1000,000 / £1,500,000) x 100 = 66%
This means the company spent 66% of revenue on selling its product or service in this period. A low COGS ratio shows that your business costs related to selling your product are low in comparison to sales, and therefore the potential profit is higher.
A lower COGS ratio means that the costs incurred in production are lower in comparison to the generated sales. In general, a COGS ratio of higher than 65% suggests that you should try to lower your production costs to allow the business to grow.
For example, if your business generates £200,000 of revenue but the COGS involved in creating that revenue are £160,000 (or an 80% ratio) then your business profits will be much lower. Despite the positive revenues, it will be harder to find the cash to invest in growth or meet sudden peaks in demand. By reducing the COGS ratio to 50%, a business with £200,000 in revenue would have an additional 30% of profit, making it easier for the business to thrive.
