One of the frequently asked questions with regard to business spending is whether the Cost of Goods Sold (COGS) and operating expenses are the same thing.
The short answer is: No.
How are they different and what impact does it have on your operational efficiency? Let’s take a closer look to identify the key differences between the Cost of Goods Sold (COGS) and operating expenses.
As the name suggests, the Cost of Goods Sold (COGS), is what your product costs you. In other words, it is the direct cost of doing business and constitutes every dollar you spent on everything that goes into manufacturing your product. This includes the cost of raw materials and direct labor, packaging, and delivery.
It doesn’t become an actual expense until you sell your product.
Take, for example, someone who sells cosmetics. Let’s suppose, they purchase $500 worth of various makeup items but could only sell $300 worth of lip gloss. In this case, the COGS is $300, while the expenses amount to $500.
Considering COGS vs Expenses boils down to the fact that business is not just about manufacturing and delivering the product and these are not the only costs incurred, it is a lot more than that. Several operations run simultaneously to make the final sale, irrespective of the size of your business. Since these overhead expenses are not directly tied to production, they are considered indirect costs of doing business, hence called operating expenses.
Here is a list of some of the most basic ones:
Payroll is ambiguous because it depends on the type of labor employed. It is either categorized as an operating expense or the cost of goods sold. If you pay wages to your assembly-line auto worker in production, those wages will fall under cost goods sold. But the payroll for administrative staff, such as receptionists, HR, accountants, sales and marketing personnel, etc. falls under operating expenses.
Another common (and valid) query is whether purchasing assets like land, building, vehicle, equipment, furniture, is also considered an operating expense. They are not. These types of costs are called capital expenditures which are the investments you make to add value to your business. However, the depreciation of these assets is considered as an item of revenue expenditure as the depreciation expense incurs due to revenue generation.
By now we understand that the difference between COGS and expenses is relative to the type of business model. Let’s take a look at COGS vs expenses in some common small business ventures.
Their operating expenses would include the costs of running the eatery, such as:
It will also include the expenses of running the head office if any:
There is also a difference between operating expenses and COGS in the way they’re reflected in your books of accounts.
When an operating expense is incurred, such as rent or insurance, the appropriate expense account, such as rent or utilities would be debited, and accounts payable would be credited.
For the cost of goods sold, your bookkeeper would debit the appropriate asset account and credit accounts payable.
As the inventory is sold, it becomes an expense, so your bookkeeper would credit the asset account and debit the related COGS account for the same amount.
Knowing the difference between COGS and Operating Expenses will help you strategize the growth of your business. Each is a performance metric for your business in the respective quarter and allows you to make informed business decisions.
COGS indicates the operational efficiency of your production, or even the lack thereof. A low cost of goods sold indicates that you have created the product with utmost efficiency, and that results in higher gross profits. This implies that to increase and maintain profitability you have to keep your production costs low. You can achieve that by reducing supplier costs or increasing the efficiency of your direct labor through different tools and training.
Operating costs, on the other hand, indicate the degree of efficiency in running your business, and are indirectly proportional to your profit. Cutting back on your marketing spending, or reducing the headcount, or readjusting your other variable expenses can help to control your operating expenses and improve your ROI.
Look for ways to tighten both, your COGS and operating expenses. Don’t let these expenses eat through your business money.
The comparison of COGS vs expenses also has some tax implications. Most of your operating expenses are deductible on your business tax returns, resulting in a reduced business income tax bill. However, your expenses should be “ordinary and necessary” to the business to come under the head of deductibles.
Keeping track of your operating expenses vs COGS can help you in determining the breakeven point for product pricing.
After having a thorough look at the COGS vs expenses comparisons made above, we can see that it is crucial to correctly record day-to-day transactions under appropriate headers of COGS and Expenses.
However, If you outsource your bookkeeping, you don’t have to worry about maintaining the books at all. Instead, you can use the data to make the necessary changes in your operations or even focus on expanding them to meet your business goals sooner.
Need further guidance? Monily’s bookkeeping services team is here to help.