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Most non-CFOs will agree that accounting is not sexy. But it is useful and can even be a powerful window into the future of a business. A humble line item in a financial statement – like Cost of Goods Sold (COGS) – can tell you a lot about your company’s ability to scale up.
COGS refers to the direct expenditure required to produce the goods or services you sell to customers. It includes labour and materials but excludes indirect costs like sales and marketing.
This article explores how COGS can be used to calculate one of the most important ratios for a growth company – gross margin – and how managing this ratio can transform your ability to scale up.
What is COGS?
COGS is the sum of direct costs required to produce a product. Direct costs include:
- materials;
- labour;
- transaction costs; and sometimes
- a portion of your fixed costs (like hosting fees for a business that sells software).
COGS appears in your Profit and Loss statement.
It can be useful to calculate the average cost to produce one widget.
This tells you the cost to produce one unit of your product, also known as your marginal cost.
Your marginal cost can be used to calculate your gross margin.
How to Calculate Gross Margin
Gross margin is the ratio of gross profit and revenue. It measures what percentage of your gross revenue (the money paid to you by customers) is yours to keep.
To calculate gross margin, subtract your COGS from your revenue and divide the result by your revenue. Gross margin is expressed as a percentage.
For instance, if my shoe manufacturing business sells $100,000 worth of shoes this month and spends $20,000 on the salaries of factory workers and $30,000 on raw materials, then my gross margin is 50%.
Continue reading this article below the formWhy Gross Margin Matters
Gross margin gives you a powerful insight into the cost structure of your business. Understanding your cost structure is critical to knowing how – and how fast – to grow your business.
Let’s look at two examples.
1. An Accounting Firm With a Low Gross Margin
A business with a lowl gross margin (<50%) only keeps a small percentage of its revenue. The remainder is paid to employees (for their labour) and suppliers (for materials and other services). The high COGS translates to a low gross margin.
An accounting firm has high COGS. For each ‘unit’ it sells, it needs to pay one of its accountants a fairly high salary to deliver the service.
For an accounting firm to scale up, it needs to hire more accountants. This takes time and incurs recruitment and training costs. Also, not every accountant will be busy with clients every day – so the COGS will include the salaries of any underutilised accountants. Clearly, growing an accounting firm is challenging and expensive. We can predict this from the gross margin.
2. A Software-as-a-Service Company With a High Gross Margin
A business with a high gross margin (>80%) keeps a large percentage of its revenue. A Software-as-a-Service (SaaS) company’s COGS consists only of hosting and supporting costs. The low COGS translates to a high gross margin.
The low COGS means a SaaS company can scale very quickly. It can sell more instances of its product to more customers with very little incremental cost. This is the reason why many of the world’s fastest growing companies have a SaaS business model.
A business with low COGS and high gross margin can also invest its gross profit in sales and marketing. This can accelerate its growth even further.
Key Takeaways
Accurately measuring your COGS allows you to calculate your gross margin. Understanding your gross margin provides a powerful tool for assessing the potential of your business to grow profitably. Businesses should work to reduce their COGS before pouring money into sales and marketing. This will ensure that you get to keep a larger proportion of the revenues you collect from new customers.
If you need assistance with the legal side of growing your business, LegalVision’s experienced business lawyers can help. Call 1300 544 755 or complete the form on this page.
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