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Small businesses are always looking for ways to boost profits, and one area to really focus on is the cost of goods sold (COGS). This includes things like labor costs and materials. By understanding your COGS, you can spot inefficiencies, like high manufacturing or labor expenses, and find cheaper alternatives.
Managing your COGS effectively is crucial because it impacts your cash flow, which is vital for keeping daily operations running smoothly. When you optimize your COGS, you improve cash flow, reduce risks, and make it easier to secure business financing.
What is COGS and why is it important?
COGS is, at its core, a measurement of how much it costs for you to make your product or provide a service. This figure goes beyond simply tracking how much you spend on raw materials since that only tells one part of the story. Instead, COGS tracks the cost of materials as well as the labor associated with production. It measures any direct costs in materials, purchases and labor that went into creating a product or service during a specific period.
Your COGS is important for three major reasons: tax reporting, growth opportunities, and profit tracking. COGS helps you accurately track your sales when tax time comes, which helps make sure you claim the most deductions and pay the right amount of tax.
This number also helps you determine which items sell better than others and where you might be able to reduce manufacturing costs, like if they’re out of sync with other products. Lastly, COGS helps you track profits by giving you a foundational understanding of how much it costs to produce your goods.
How to calculate your COGS
Avery’s Amulets is a little shop on Main Street that’s devoted to baubles. She has more than $3,000 worth of jewels in inventory at the beginning of the year. She also makes an additional $1,500 worth of goods throughout the year. That means that Avery has $4,500 worth of stock. Avery’s Amulets amasses an astounding number of sales that leaves her with only $430 worth of inventory by the end of the year.
Avery adds it all up with the following formula:
Beginning Inventory ($3,000) + Additional Inventory ($1,500) – Ending Inventory ($430) = COGS ($4,030)
Therefore, Avery’s COGS for the year is $4,030. This means, that in the next year, she knows that it will take a minimum of $4,030 to produce the same amount of goods. Unless she’s able to find efficiencies or there’s a rise in the cost of materials or labor that’s simply beyond her control.
How to control your COGS
Avery wants to bring her COGS to heel — namely, she wants to reduce her labor costs per item. This would help dig her out of a cash flow problem since the bauble business requires a ton of up-front payment for raw materials.
Avery might be able to find savings by automating some of her work, so she buys the Recom”bauble”lator 3000, which lets her build baubles in a fraction of the time. This helps her reduce labor costs, since she no longer needs to employ part-time employees to help her out.
This is only one way to control COGS. The other is buying materials at a better price. Avery doesn’t want to invest in a Recom”bauble”lator 3000 and would rather be loyal to her employees. Preferring a human touch, she works out new terms with her gold supplier, which gives her better bulk pricing to produce a bevvy of baubles for less money. This helps her reduce her COGS by lowering materials costs.
Why controlling COGS is key to cash flow
Buying equipment and paying to put it together isn’t cheap. Any time you pay more than you need to when creating inventory, you leave money on the table. Keeping track of COGS can help significantly here. It provides you with clues on where you can minimize costs and optimize your company’s operations.
Keeping costs down helps free up cash. Which, in turn, helps you keep your cash flow steady. The more you can free up cash, the better your cash flow gets. Having your COGS at the ready helps you determine where your company is making the most of its available cash, and where there might be a drain on resources.
To get a further handle on your business and its financial health, you can connect your QuickBooks Online or Xero account to Forwardly to get detailed financial reports and cash flow forecasts.
