COGS vs. operating expenses: understanding your business expenses better

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Cost of goods sold (COGS) and operating expenses (OPEX) are two essential components of your financial statement. COGS refers to the direct costs of producing the goods and services sold by a company. OPEX are the costs associated with a company's administrative operations. Both COGS and OPEX play a crucial role in determining your business’s profitability. 

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As the President of Brady CFO, a fractional CFO service firm, I have extensive experience helping companies manage their cost of goods sold and operating expenses to optimize their financial performance. My expertise lies in identifying cost-saving opportunities and pricing/revenue analysis to ensure my clients have the right pricing structure to cover their costs. Over the years, my goal has always been to make sure these businesses are not only keeping their costs under control but also maximizing their profitability and enhancing their financial health for the long term.

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A clear understanding of these costs allows you to analyze your business's financial health accurately. By monitoring these expenses, you can identify opportunities to improve your profit margins. Furthermore, understanding COGS and OPEX can help you price your products or services appropriately, ensuring you cover all your costs and maintain profitability.

What’s the difference between COGS and OPEX?

The difference between the cost of goods sold and operating expenses largely lies in their relation to the production and administration of a business. COGS refers to the direct costs attributable to the production of the goods sold by a company. This includes the cost of the materials used to create the goods and the direct labor costs used to produce them. It excludes indirect expenses such as accounting or marketing costs. 

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On the other hand, operating expenses are the costs associated with running the company’s day-to-day operations that aren't directly tied to production. For example, these can include:

• Rent
• Utilities
• Office supplies
• Administrative employee salaries
• Other administrative costs, such as insurance, legal, etc. 

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Both the cost of goods sold and operating expenses impact a company's income and overall profitability, but they do so in different ways and are categorized separately in financial statements for clarity and accuracy.

Examples of COGS in business operations

Cost of goods sold is easiest to analyze if you are selling a product. However, if you sell services, you can still track costs with a “Cost of Services” model. In either situation, COGS is the direct cost that increases with a direct proportionate increase in sales. 

COGS in manufacturing

Suppose your company manufactures furniture. The total cost of nails and wood used to assemble the piece of furniture is what makes up COGS once that piece of furniture is sold.

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Keep in mind that a manufacturing company can manufacture a product and not have any sales against those products. When this is the case, the manufacturer records all of its costs in Inventory. When the product is sold, Inventory is relieved, and the total inventoried costs of that item sold are moved from Inventory to COGS on your income statement. 

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The aim of this accounting method is to determine whether, after subtracting direct costs from sales, the company earns a sufficient gross profit margin per unit sold to offset its fixed or operational expenses, like accounting salaries, insurance, and so on.

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This allows you to determine if target margins are being hit or not. If margins are not being hit, then either the sale price of the product sold needs to increase or the cost of the item manufactured needs to decrease.

COGS in services

In a consulting environment, the salary, benefits, and pay of your consultants are the COGS. You are selling consulting services. So, your direct costs that rise in proportion to your sales of consulting services are your employees on payroll who are directly involved in providing your consulting services.

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These costs increase proportionally with the number of consulting services you sell. If you take on more projects, you'll likely need to allocate more consultant hours, potentially hire more consultants, or pay overtime. All of these actions increase your direct costs—ergo, your COGS.

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We’ve worked with a company operating in the service industry and found their accounting team wasn't properly categorizing COGS for vacation and sick days and other benefits of service-based employees. They were including these costs in OPEX. This issue was significant because the client's bids aimed at a specific gross profit margin. Although they met this margin on their financials, it was inaccurately reported, leading to an underestimation of gross profits by about 1–2% of sales. This also meant they were underpricing their services without properly accounting for all these costs. We helped them resolve this by working with the accounting team to correct the accounting and develop a new pricing plan going forward. 

Examples of OPEX in business operations

Operating expenses are the overhead costs incurred that can't be tied directly to a particular sale. These expenses are often referred to as SG&A (selling, general, and administrative expenses). These are the salaries and expenses related to staff that aren't involved directly in producing products or services for sale.

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For example, hiring an accountant doesn't produce a direct increase in sales. Over time, hiring that accountant might free up an owner to focus on more sales and help the business grow long-term, but it's the idea that the accountant's pay and benefits can't be directly tied to a direct/proportionate increase in sales.

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In general, OPEX in business are fixed costs. For instance, your total cost of accounting salaries isn't necessarily expected to change if your sales increase by 10%. These costs are fixed in nature and change at certain strategic increments rather than according to direct variations in sales.

COGS and OPEX in comparison to sales

Now, with this understanding comes the very important question: What should my COGS and OPEX be in comparison to my sales? First, looking into industry averages helps provide a baseline understanding of COGS and OPEX for your industry. A great starting point to find this data is Vertical IQ. They are a helpful resource to understand industry fundamentals and financial benchmark ratios for various industries.

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Second, the answer somewhat depends on your overall strategy. For example:

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• Discount retailer: Let’s say your COGS is high in comparison to your sales because you discount your prices. However, your OPEX is low because you spend very little on marketing and sales. The low-price nature of your products attracts a lot of customers, and you produce a strong net income. In this case, you are fine.
• Luxury retailer: In this case, let’s say you have a much lower COGS in comparison to sales because of your luxury pricing. However, your OPEX is substantially higher due to having to spend more on marketing to advertise your products to the right market. Even with this strategy, you may be able to produce a great net income.

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As you can see in the examples above of two different retailers, their business strategies demand different COGS and OPEX in proportion to sales, but both could still earn sufficient profits.

How to use COGS vs OPEX to improve your bottom line

Running a business with a high cost of goods sold and operating expenses relative to sales can put your enterprise at a significant disadvantage, especially when compared to industry peers. 

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High COGS indicates that you're spending a lot to produce your goods or services. If these costs are excessively high compared to the income you're generating from sales, it could mean your pricing strategy needs adjustment, or you need to find ways to reduce production costs. Similarly, high OPEX signifies substantial costs in maintaining your business operations. If these costs are too high, it might imply inefficiencies in how your business is run.

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When both COGS and OPEX are high relative to sales, it squeezes your profit margins, making it challenging to generate a healthy net income. This situation becomes even more critical if your competitors are managing their COGS and OPEX more efficiently, leading to better profitability. They may be able to offer competitive pricing, invest more in growth initiatives, or weather financial downturns more effectively.

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Therefore, it's crucial to continuously monitor and optimize your COGS and OPEX. Proper management of these costs is a fundamental stepping stone on the path to success. It paves the way for financial stability and shields your business from potential economic pitfalls. Embracing this proactive approach not only helps avoid financial difficulties but also fosters sustainable growth, making it a crucial strategy for any thriving business.

Manage your COGS and operating expenses with Ramp

Ramp’s expense management software can help you manage and cut down on your COGS and operating costs. Ramp pairs with leading accounting solutions to help you control unnecessary spending and take control of your business's cash flow.