This is part 3 of a short series discussing the basics of the income statement. See part 1 for a general overview, and part 2 for more info regarding revenue. In this post, we’ll be talking about costs of goods sold.
In general, costs of goods sold are going to be variable expenses that rise and fall with revenue. Common examples are material purchases, direct labor, freight, basically anything that was directly needed in order to fulfill a sales obligation. If you’re trying to decide if an account goes here or somewhere else, ask yourself if sales stopped tomorrow, would this expense still continue? If the answer is no, then it may not be fitting for this category.
It’s true there are some fixed types of expenses that can make it into costs of goods, such as allocating part of your lease proportionate to your warehouse space. There are fewer examples of fixed costs that go here, so for simplicity’s sake it’s ok to think of this as generally variable and directly tied to sales.
When looking for what level of detail is appropriate, a great place to start are your revenue accounts. Costs of goods should mirror revenue accounts as much as possible. A dentist may track revenue from hygiene separately from procedures carried out by a dentist. In that case, hygiene labor and materials would ideally be stated separately from dental labor and materials. Another business may track domestic sales vs. international, so costs of sales should do the same. This separation allows further insight to service specific profit margins and helps verify each product line is profitable on its own and not just being carried by something else. I’ve seen businesses slowly pivot their entire company’s offering based on identifying high margin niche services that would otherwise be hidden in lump figures.
That said, just like the revenue section, there aren’t many requirements forcing you into a ton of detail. If you’ve discovered a great way to separate revenue figures but can’t figure out how to split out materials for different product lines, you can just do one cost of sales materials account for now. A long-term goal may be to find a way to split this out, but there are no accounting requirements forcing you to do so. Some costs of goods sections may simply show material purchases and direct labor. Some businesses may use estimates, for example if material costs and uses are similar across different services, you may split this out in costs of sales based on revenue percentages. Always be careful when making decisions based on estimates, but I would argue a good estimate, while imperfect, is still better than nothing at all.
Getting the costs of goods section right is going to be critical to managing your business. As your company grows, these expenses will grow right along with it. Understanding what your costs are and how they fluctuate with different product lines can be a game changer. This is a place where you want to spend a lot of time, as a few percentage points of savings in this area can have huge returns. A 2% savings in costs of goods to a $5m company is $100,000, compare that to stressing over something like overspending a few grand on office supplies.
Revenue and costs of goods sold are the most valuable parts of the income statement and mastering them is imperative. Up next, we’ll be touching on operating expenses and finally other income and expense both of which, though not as critical, are also important pieces of the income statement and should not be overlooked.
If you have questions on how to properly prepare your income statement, please contact us.