Cost of Goods Sold (COGS) is the direct expense a business incurs to produce the goods it sells. It is also referred to as variable costs because COGS are intended to vary with sales.
Primary Implication
Profitable businesses will have direct costs that vary with gross sales. The failure of a “variable expense” to decrease by a similar percentage or less when sales decrease is an operations management failure.
The result is their cash outflows exceed their cash inflows. Correct this by monitoring your actual COGS relative to your planned COGS as a percent of sales. When they become out-of-balance, you have an area of profit loss to fix.
Overview
Cost of Goods Sold or COGS consists of every direct expense related to producing the goods and services bought by your customers. COGS are considered variable expenses because they vary with sales. The most costly COGS are most often Direct Labor, Subcontractors, Materials, and Equipment.
When accounting for COGS, consider what is being recognized as a direct expense in what is being produced. If an expense accounted for here doesn’t change as sales levels change, then it’s a fixed, not a variable, expense. Two issues to consider if this is the case.
- The expense is a direct cost and should vary with sales, but isn’t. Allowing a variable expense to become a fixed expense is an operating management problem that needs immediate attention. Determine why it’s not varying with sales and make it a variable expense again. This way, the expense cost declines when sales decline, reducing your cash outflow obligations.
- The expense is not a direct cost and is accounted for in the wrong chart of account. Calculating an accurate gross profit is difficult if you have variable costs in SG&A and fixed costs in COGS.
Most small businesses fail because they take on too many fixed expenses. A review of where their expenses are too high relative to their sales often reveals that they have allowed variable costs to become fixed costs. They fail to adjust their direct costs down as sales decrease, resulting in poor cash quality.
Every business should always have a recurring business goal to reduce their direct costs related to producing the goods and services bought by their customers and accounted for within their Cost of Goods Sold. Those who want to become good at making more money with less stress use the BusinessCPR™ Management System to make more money through higher profits, predictable cash flow, and cash reserves in the bank.