For many years, craft retailer Sugar Bowl Crafts has sold fabric squares to crafters and quilters around the world. The profit margin on each square is small, so it’s vital that founder Mel Lewis understands the cost of goods sold (COGS) in order to ensure that she charges the right amount to turn a profit.
This understanding became particularly important during lockdown when there was an explosion in demand for craft materials. Lewis could not meet demand from customers placing orders for packages containing numerous different fabrics and materials.
“When we sat down with the accountant and looked at the cost involved in assembly, packaging and shipping, the profit margin on orders was very tight,” says Lewis. “As a result, we started selling pre-assembled bundles, which had similar costs around packaging and shipping but were much quicker to assemble and process, so we could drive up the profit margin and meet the increased demand from customers.”
Understanding COGS is more than simply building a list of your product, material and labour costs. Tracking COGS regularly can provide valuable insight into how to maximise new business opportunities and respond quickly to changes that could impact your profit or growth.
What is included in COGS?
According to award-winning business coach and growth consultant Sara Tye, when calculating COGS, companies should take account of all costs that would not be incurred without a product or service being sold.
“Many companies fail to account for all direct costs, which can be a huge risk to viability,” she warns.
Most 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. Tye, who advises clients on business strategy, explains: “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.”
How do you work out COGS?
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. It can be expressed using a formula, such as:
Opening inventory + net costs – closing inventory = Cost of Goods Sold
The leadership team at virtual assistant platform Time Etc tracks COGS when providing its services to clients, says founder Barnaby Lashbrooke. “Understanding our cost of goods is critical for calculating what we can afford to pay our assistants,” says Lashbrooke. “It also clarifies where and when we can afford to invest in the business.
“That [clarity] was critical when we launched in the US and needed to invest in marketing without compromising our profit margin.”
Time Etc charges customers an hourly rate for its services, and the costs associated with delivering the product must be carefully tracked and adjusted to generate a healthy profit. For example, when staff costs started to increase in 2021 in response to increased competition and a rise in the cost of living, Lashbrooke used COGS analysis to track the changing costs involved in delivering the company’s services.
With a clear view of COGS, Lashbrooke was able to identify a potential cost saving in licensing the software used by virtual assistants. Reducing this cost helped fund a 5% pay increase for the virtual assistants without increasing overall COGS. An additional benefit of keeping COGS steady was that the company did not need to increase pricing for existing customers, helping Time Etc to remain competitive.
Cost of goods sold example
Some common examples of costs that fit under cost of goods sold include:
- Labour costs, including salaries and additional costs around payroll, benefits, and HR administration
- Manufacturing costs, including the cost of machinery purchase, assembly and maintenance costs
- Raw materials, which can include items sourced from third parties
- Shipping, not only to the customer but also to your warehouse/premises
- Administration costs, which can include direct marketing spend, creative costs such as design and labelling, and management time that can be directly attributed to a specific product or service
Tracking COGS can provide valuable insight into understanding the timing of your business costs, not just the totals. This paves the way to shortening the gap between incurring expenses and receiving payment from customers. When you use an American Express® Business Gold Card to pay for production expenses, you get up to 54 days to clear your balance. This gives you the flexibility to spread costs and better manage your outgoings¹. Plus, for every £1 spent on your American Express Business Gold Card, you earn 1 Membership Rewards® point, which you can use as statement credit and further mitigate against the cost of goods sold².
COGS shouldn’t include overhead costs, such as rent, utilities and operating costs. These costs can’t be directly attributed to a specific product or service in most cases and will exist even if a sale isn’t made.
Why do you need to understand COGS?
It is important to understand COGS finance metrics so that you know how to price products and services appropriately, says Tye. “COGS can help you understand the true profit margin of your key products and understand what contribution they make to profitability,” she says. “Without that insight, there is always a risk that you are selling something at a loss.”
The risk of selling at a loss is something of which Lewis is very much aware. “The profit margins on our craft kits can be relatively small, at just a few pounds per product,” she says. “It’s critical that we understand the full cost of supplying those goods because we don’t want to make a loss, but we also want to know which products generate the best return on investment.”
In addition, having visibility of the direct costs involved in making your product allows you to decide when best to invest in additional materials, labour, or stock.
How does COGS improve profitability?
COGS improves profitability by giving companies a clear view of the total cost of delivering a particular product or service to their customers. Businesses can then make better decisions around pricing, budgets, and investment planning.
Calculating COGS can be done internally if you have the right expertise and the time available. Where those skills don’t exist inside the business, it’s best to work with your accountant, says Lewis. “Communicating with the accountant and having regular updates on revenue versus cost means I understand better how the business is performing and which product lines contribute most to our profitability,” she says.
- The maximum payment period on purchases is 54 calendar days and is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date. If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – the Business Basic Card.
- Membership Rewards points are earned on every full £1 spent and charged, per transaction. Terms and conditions apply.
