COGS is an essential metric for companies that sell products. But what if you have a service-based business? Should service businesses use cost of goods sold?
When you think about cost of goods sold (COGS), you might think of a wholesaler or retailer who sells physical products, also known as “goods.”
Companies that sell products account for costs of goods sold on their profit and loss statement, and it’s an essential metric for understanding the total amount the business paid for expenses directly related to the sale of products.
But what if you have a service-based business? Should service businesses use cost of goods sold?
Cost of goods sold (COGS) and cost of services (COS) are two important concepts in accounting and finance that business owners need to understand Though they sound similar, there are some key differences between COGS and COS that impact how they are calculated and analyzed In this comprehensive guide, we’ll break down what COGS and COS are, when to use each, and how to calculate them for your business.
What is Cost of Goods Sold?
Cost of goods sold (COGS) refers to the direct costs attributable to producing goods that a company sells. This includes the cost of materials, direct labor, and any other overhead costs directly related to production. Simply put, COGS captures all the variable costs incurred to manufacture products.
COGS does not include indirect costs like distribution, sales force salaries, or administrative salaries. These operating expenses are accounted for separately on the income statement. By subtracting COGS from revenue, you arrive at a company’s gross profit or gross margin. Monitoring COGS is critical for businesses that manufacture and sell products to understand profitability.
Common Examples of COGS
- Raw materials used to produce goods
- Direct labor costs of workers assembling products
- Factory overhead like equipment maintenance and utilities
- Packaging and shipping costs of finished goods
COGS helps businesses determine the cost to produce each product they sell. This informs pricing and profit margin decisions. Tracking COGS over time also provides insights into production efficiency – are costs rising or falling per unit produced?
What is Cost of Services?
Cost of services (COS) is similar to COGS but applies to companies that sell services instead of physical products. COS captures the direct costs incurred to deliver services to customers. This includes labor, materials and other expenses directly related to providing the service.
Anything not directly tied to service delivery is not included in COS – for example, sales commissions, administrative overhead, marketing costs, etc. By subtracting COS from service revenue, you get a service company’s gross profit/margin. Analyzing COS helps service businesses understand their profitability and pricing.
Common Examples of COS
- Labor costs of service providers
- Costs of materials consumed in delivering the service
- Travel expenses to client sites
- Facilities expenses tied directly to service delivery
Law firms, consulting firms, restaurants, salons, and other service businesses all rely on accurately calculating COS to make sound business decisions. It provides insight into the true cost of delivering core services.
Key Differences Between COGS and COS
While COGS and COS serve similar purposes, there are some important ways they differ:
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Applicability: COGS applies only to companies selling tangible products. COS applies to companies selling intangible services.
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Inventory: COGS is deducted when a product sells, reflecting the cost of inventory sold. COS is deducted immediately since services don’t remain in inventory.
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Direct costs: COGS includes production-related costs only. COS includes service delivery costs like labor and travel.
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Timing: COGS deductions align with sales. COS deductions align with when services are actually delivered.
These core differences stem from the inherent contrasts between producing goods and providing services. Both are critical metrics, but companies should be careful to apply COGS and COS in the appropriate context.
How to Calculate COGS
Calculating COGS involves summing up the costs directly tied to manufacturing products sold during an accounting period. Here is the formula:
COGS = Beginning inventory + Production costs – Ending inventory
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Beginning inventory is the costs of unfinished goods and materials held at the start of the period.
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Production costs are the direct expenses incurred to produce goods during the period, including materials, labor, and factory overhead. This can also include freight for shipping materials.
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Ending inventory represents the costs of unsold goods still on hand at the end of the period.
For example:
Beginning inventory: $100,000
Production costs: $200,000
Ending inventory: $50,000
COGS = $100,000 + $200,000 – $50,000 = $250,000
Companies that manufacture inventory should conduct a physical inventory count to accurately measure beginning and ending inventory. COGS will vary depending on how inventory turns over in any given period.
How to Calculate COS
Calculating COS for service companies involves totaling up direct costs of delivering services for the period:
COS = Labor costs + Materials costs + Other direct costs
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Labor costs include wages, taxes, benefits, and other compensation for employees involved in service delivery.
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Materials costs reflect supplies, consumables, and other items used up in providing the service.
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Other direct costs can include travel, facilities, commissions, and other expenses tied directly to servicing customers.
For example:
Labor costs: $125,000
Materials costs: $50,000
Other direct costs: $20,000
COS = $125,000 + $50,000 + $20,000 = $195,000
The calculation is straightforward – add up all direct costs of servicing customers during the period. There is no inventory component to factor in.
Why COGS and COS Matter
Accurately calculating and analyzing COGS and COS serves several important purposes:
Measure profitability – Subtracting COGS and COS from revenue shows a company’s gross profit and margin. This is a key profit metric.
Set pricing – Understanding COGS and COS provides a floor for product/service pricing so profit margins can be maintained.
Identify efficiency issues – Fluctuations in COGS/COS per unit can signal improving or worsening production/service delivery efficiency.
Determine cost drivers – Increases in certain COGS/COS line items helps management identify what’s driving up costs.
Benchmark competitors – Comparing COGS/COS as a percentage of revenue benchmarks a company against competitors.
Value inventory – COGS helps determine the cost of unsold inventory at the end of an accounting period.
For both product and service companies, keeping close tabs on these costs is vital for making smart business decisions. Analyzing COGS and COS trends over time provides actionable insights for management.
Best Practices for Managing COGS and COS
Here are some tips for effectively managing COGS and COS:
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Review COGS/COS frequently – don’t just look at these annually. Spot trends sooner.
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Break down costs in detail – analyze the components including labor, materials, and overhead.
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Look at COGS/COS per unit – identify inefficiencies as costs rise on a per unit basis.
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Use technology to track costs – manufacturing software and service software can provide visibility.
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Compare to budgets – set realistic COGS/COS budgets and measure against them.
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Identify drivers of cost changes – don’t treat COGS/COS as a black box.
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Benchmark against competitors – see where your COGS/COS stands in the industry.
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Consider opportunities to outsource – sometimes third parties can manufacture/service more efficiently.
Proactively addressing COGS and COS allows businesses to spot issues faster and gives more time to respond appropriately. View them as living metrics requiring ongoing attention.
Striking a Balance on COGS and COS
Monitoring and optimizing COGS and COS certainly provides financial benefits, but companies shouldn’t take it to an extreme. Quality and customer service should not be sacrificed solely to drive COGS and COS down.
There are situations where accepting higher COGS or COS in the short term makes sense for the business:
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Using higher-grade materials that improve product quality
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Investing in more highly-skilled labor to deliver premium service
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Taking more time to manufacture/service products meticulously
The bottom line is that minimizing COGS and COS at the expense of all else is not prudent. Companies have to strike a balance between profitability, quality, and customer satisfaction. Some situations warrant accepting higher production or service delivery costs.
Key Takeaways on COGS and COS
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COGS applies to product companies and captures direct production costs
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COS applies to service companies and captures costs to deliver services
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COGS is deducted when inventory sells; COS is deducted immediately
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Analyzing COGS and COS reveals production/service efficiency and profitability
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Regularly monitor COGS/COS components for cost management
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Don’t minimize COGS/COS without considering quality impacts
Understanding these fundamentals will help your business apply COGS and COS appropriately. Keep an eye on the trends and ratios but also the contextual factors driving them. With this balanced approach, your business can optimize profitability while delivering quality products or services that meet customers’ needs.
Cost of Goods Sold for a Service-Based Business
Service-based businesses generally aren’t required to account for inventories and cost of goods sold. However, it might make sense in some cases.
Let’s consider 2 fictional companies and whether it would make sense to account for cost of goods sold.
Matlock & Associates is a law firm representing clients accused of criminal activity. They don’t sell any products, but preparing for a trial typically involves a lot of printer paper, legal pads, pens, sticky notes, and coffee.
These items are inexpensive, and it wouldn’t be worth their time to keep track of each piece of paper or pen. So the firm doesn’t account for inventory or cost of goods sold and instead deducts those items as materials and supplies in the year they pay for them.
On the other hand, Hot Spot HVAC Services is an HVAC company that installs and repairs air conditioners and furnaces. The company writes off many incidental materials and supplies, such as coils, ducts, and vents. However, they also keep an inventory of more expensive parts on hand so that technicians don’t have to make time-consuming trips to a local supply depot or leave customers hanging when a crucial part is out of stock.
So, Hot Spot HVAC Services does keep track of inventory and show COGS on its financial statements.
So, if it makes sense for your business, you can opt to track cost of goods sold. Most service-based businesses that do refer to it as “cost of sales” (COS) or “cost of revenues.”
How to Calculate Cost of Goods Sold
The formula for calculating COGS is:
beginning inventory + purchases – ending inventory = cost of goods sold
Beginning inventory is the ending inventory from the prior year’s financial statements. You add to that figure any additional stock purchased during the year, then subtract any inventory remaining at year-end.
Returning to our Hot Spot HVAC Services example, say the company had $10,000 of inventory in the warehouse as of December 31, 2021. In 2022, the company purchases an additional $11,000 of parts. On December 31, 2022, they take a physical inventory count and determine there is $8,000 of inventory on hand.
Hot Spot’s COGS for 2022 would be:
$10,000 + $11,000 – $8,000 = $13,000
Depending on your needs, your service-based business might also include:
- Direct labor for the employee wages for people who perform the service
- Sales commissions paid to sales representatives
- Incidental materials and supplies that go into completing the service
- Fuel costs for employees traveling to and from job sites
Understanding Costs of Goods Sold for your Service Business
What is cost of goods sold (COGS)?
Cost of goods sold, or COGS, is a metric used primarily by product based companies and industries that determines how much your organization spends on product-related expenses. COGS do not include any overhead or fixed costs your company incurs whether or not you sell any products.
Do service companies have a cost of goods sold?
Many service companies do not have any cost of goods sold at all. COGS is not addressed in any detail in generally accepted accounting principles (GAAP), but COGS is defined as only the cost of inventory items sold during a given period. Not only do service companies have no goods to sell, but purely service companies also do not have inventories.
Is cost of goods sold an expense?
Yes, cost of goods sold is an expense. It refers to the costs associated with products or services that have been sold to customers. This includes direct production costs such as raw materials as well as indirect costs such as labor and overhead costs related to manufacturing and distribution.
How is cost of goods sold calculated?
Cost of goods sold (COGS) is calculated by adding up the various direct costs required to generate a company’s revenues. Importantly, COGS is based only on the costs that are directly utilized in producing that revenue, such as the company’s inventory or labor costs that can be attributed to specific sales.
