Updated November 24, 2020
What is cost of goods sold (COGS)?
Cost of goods sold (or COGS) are the costs that are directly attributable to the goods your company sells. This includes the materials or parts that go into your product, as well as the direct labor costs associated with creating that product. Direct labor costs are the labor that is part of the production process and is involved in actually creating finished products.
COGS is similar to variable costs. If you are a retail business and purchase finished goods inventory from your suppliers, then your entire COGS may be the wholesale purchase price from your suppliers. If there are steps you need to take to make a finished product, those costs may also be a part of your COGS.
The formula to calculate COGS is:
COGS = Beginning Inventory + Purchases During a Given Period – Ending Inventory
Components of COGS can include direct costs such as:
- Cost of raw materials
- Cost of shipping charges or duty fees
- Direct labor costs for products
- Overhead that can be directly attributed to production
Why is COGS important?
COGS is a very important part of the gross profit equation:
Gross Profit = Revenue – COGS
Gross profit is the profit margin your company makes after subtracting the costs of your products. It does not take into consideration fixed costs like rent, insurance, or your POS system. Gross profit is an important financial metric because it shows whether your company is profitable on a unit economics basis – in other words, an individual product is only profitable if it has a positive gross profit.
There are reasons why you may want to have a negative gross profit on a product – such as having a loss leader – but in general, most retail businesses aspire to have a positive gross profit on all of their products. Of course, your retail company has many other expenses, which is why there is also another profit measure – net profit – that is a better reflection of whether your company is viable long term.
Understanding your company’s COGS can also help you compare your products to one another and determine which is contributing the most to your company’s margin. There may be some products that are not profitable to make because their COGS is higher than the revenue they generate. As a manager or owner, this can help you be strategic in the types of products you develop and continue to manufacture or offer.
A lower COGS not only increases your company’s gross profit but also its net profit. Achieving a lower COGS also frees up money for you to reinvest into your new business by developing new products, or hiring new staff.
Reducing COGS is easier said than done
Reducing COGS sounds great in theory, but is actually quite difficult. As a business owner, you have probably already put a great deal of effort, whether conscious or unconscious, into making sure your business is profitable. One of the most important mechanisms is monitoring the price of your inputs.
Here are 5 strategies for reducing cost of goods sold for your small business:
1. Negotiate with suppliers and vendors
Strong relationships with your suppliers is key to the success of your business, but that doesn’t mean you can’t try to get the best deal. In order to reduce your COGS, develop a systematic approach for negotiating with suppliers, whether new or existing. You want your suppliers to be profitable just like you are, but you want to avoid leaving too much money on the table.
Negotiable items with suppliers and vendors can include: asking for bulk discounts; asking for a discount in exchange for paying invoices more quickly; joining formal or informal buying cooperatives, where multiple retailers can join forces to negotiate for better prices; and periodically sending projects or orders out for a competitive bid.
Be mindful of possible negative externalities of all of these strategies. For example, if you get a discount in exchange for a bulk order, you will need to store that as inventory, which will create storage and handling costs. Inventory may also become obsolete and have to be written down. Make sure you come to all negotiations armed with data about how a supplier’s products are performing on the shelf or holding up in your products, how that supplier is performing as a partner, and what kind of a deal you need to make this supplier relationship viable.
2. Swap in lower cost materials, but not to the detriment of your products
In a retail business, it is likely that the largest component of the price you pay to your supplier or your overall COGS is your materials costs. The only COGS component that may rival it is direct labor costs. It is likely that you have choices about the materials that your suppliers use to create products for your retail business. Where possible, you might opt to change the materials in order to reduce the cost of manufacturing your product and thus your COGS.
Have you shopped around for materials recently, or explored whether new technology has made a comparable and lower cost material available? You might also test whether a component of your product is or is not important to your customers. For example, if your product is made of pricey recyclable material, but you find that this is not that important to your customers, you might switch to a less expensive input material. You want to be careful, however, to not erode the quality of your product through an obsessive pursuit of a lower price.
3. Invest in automating processes
If your business participates in the creation, adjustment, or readying of the products that you sell retail, investigate whether there are processes that you can automate in order to reduce the direct labor or direct manufacturing costs. If you purchase finished goods inventory from a supplier, ask your supplier whether they are investing in automation to reduce their costs. If you find out that they are, you might use this as a negotiation strategy and ask them to pass along some of the savings to you. There may even be an opportunity to partner with your supplier to invest jointly in automation processes that are mutually beneficial to both companies.
4. Offshore your operations or manufacturing
A common strategy to reduce cost of goods sold is to offshore manufacturing of your retail goods. Manufacturing suppliers in Asia and South and Central America may be able to offer lower prices because of a lower cost of inputs and a lower cost of direct labor. However, be sure to understand the costs of offshoring, which can be both episodic and permanent. There can be considerable one-time transition costs and there can be long term expenses including travel expenses, emergency airfreight, tariffs, currency risk, communication challenges, and quality issues.
5. Eliminate waste
Waste can be a large component of COGS, and it comes in many forms. When manufacturing a product, there may be excess material that can’t be used. In some cases, you may have to pay to dispose of it. At your factory or supplier’s factory, there may be labor time waste consisting of downtime. An operations audit may help you reduce manufacturing waste. There may also be theft, sometimes called shrinkage, in your stores or throughout your supply chain. Shoplifting is a major component of shrinkage, but things such as return fraud and employee theft are also risks. These expenses can add up and are worth investigating and systematically remedying in order to reduce your COGS. Investing in better store organization and surveillance may help reduce shrinkage.