Business owners/managers will often place more focus on selling than on buying, and that’s natural. You may be surprised though, if you can spend a little time looking at your costs, at how much you can improve your profit.
A small reduction in costs can often achieve a far better result on the ‘bottom line’ than a large increase in sales, and can be a lot easier to achieve, in some cases.
There are generally two types of costs in business
- Direct Costs or COGS (Cost of Good Sold)
- Indirect Costs or Overheads.
COGS are sometimes referred to as COS or Cost of Sales.
The difference between COGS and Overheads is, COGS mainly only occur when you sell something, whereas Overheads occur whether you make a sale or not. e.g. Rent is an overhead, as this has to be paid whether you make a sale or not, whereas purchase of stock or paying service deliverers only occurs when you sell something.
The reason it is important to differentiate between COGS and Overheads, is because every business needs to know its Gross Profit. Gross Profit is calculated by subtracting the COGS from the Income or Revenue figure. Gross Profit is an early and important indicator of business performance, both for managers and lenders. It’s also an important benchmark against which to measure a business against others in its industry.
We suggest you get into the habit of monitoring the Gross Profit percentage. A percentage is an easier measure to monitor than a dollar figure. With a dollar figure you can’t easily see if the gross profit level is being maintained if revenue is rising or declining.
Whereas with a percentage it’s easier to see if you are going backwards or forwards.
Here is an example of why Gross Profit percentage is more important to know than the dollar figure.
In this example you can see the circled figures show the real result rather than just looking at the Gross Profit dollar figure. We could be tricked into thinking this is a great result because Income and Gross Profit have risen, until we consider that the slip of 3% on Gross Profit percentage has cost the business $45,000.
Similarly it’s important to monitor the COGS percentage as well as the dollar figure.
This helps you to quickly identify if costs are creeping up. Once you know this you can take quick action to maintain your Gross Profit levels, by increasing prices or negotiating with suppliers for better purchase pricing or seeking other suppliers.
It is so easy to keep on buying from the same old supplier because you always have. There was one example recently of a business who approached their regular supplier of packaging for a better price and were turned down.
They sought another supplier of the same goods and were offered a 10% discount from them. When they went back to the old supplier and told them of the 10% discount they were immediately offered the same price from them.
This item was a large portion of the COGS for this business, so the impact on their gross profit was significant. Imagine if they had gone along with the old supplier for the foreseeable future, how much this would have cost the business in lost gross profit?
What type of costs are classified as COGS?
- Purchase of stock to sell
- Movement in stock held i.e. what was held at the beginning of an accounting period versus what was held at the end of the period.
- Freight costs to get goods into and out of stock.
- Labour costs relating to production of a service or product.
- Importing costs e.g. duties etc.
- Discounts given
- Stock adjustments/wastage
- Purchase returns and allowances
- Raw materials
- Manufacturing costs
- Other costs to get goods or services ready for sale.
Example of how this works.
COGS are often the most ‘sensitive’ Key Financial Driver in relation to financial results. For one business a 1% reduction in COGS% can add $37,000 onto profit and $35,000 cash back into the bank. This is a healthy result for a small amount of work. Whereas, in the same example, an increase in revenue of 24% would be needed to achieve the same increase in profit.
If you’re in a service business don’t think that COGS doesn’t relate to you, because you don’t sell products. A factor in COGS for service businesses is ‘Work in Progress’ (WIP).
Many service businesses have no real methodology for handling Work in Progress or Jobs. Getting this function under control in your business can have a huge impact on profit and cashflow.
We can show examples where a five day reduction in the average WIP days can put $35,000 back into the bank account. When one client, an electrical contractor was asked, how often he did his invoicing to customers … his answer was … “When I run out of money!”.
It is not very difficult to put in place a process for ensuring jobs get invoiced out as quickly as possible, therefore speeding up payment and reducing cash-flow squeeze. There are ways that easily speed up WIP and jobs, and the resulting improvement in profit and cashflow far outweighs the cost. Once you have these systems in place, they are there forever and you need to spend less time worrying about cash flow and profitability in the future.
Don’t wait until the end of the financial year to look at these percentage results. Most good accounting systems have a report that calculates percentage figures on the Profit and Loss Report. If you need advice or hands-on help with these issues call us.
Budgeting for COGS is an important function in monitoring profitability. COGS can very easily ‘creep up’ without you realizing it. These increased costs need to be passed onto customers in order to maintain margins. Keeping track of such costs may seem like a pain, but the resulting control over margins and profitability far outweighs the cost of maintaining such control.