How to Evaluate Your Cost of Goods Sold to Determine Your Profits
woman looking at a sales tag

Four considerations for a complete evaluation of COGs and the value derived from purchasing goods should include direct costs, indirect costs, and non-monetary/hidden costs.

When a company purchases inventory or materials that create revenue, the line item for these direct expenses is reflected on their Profit & Loss (P&L) statement as Cost of Goods Sold (COGS), in accordance with General Accepted Accounting Principles (GAAP). This allows management to evaluate their gross profit margin.

However, accountants itemize many of the expenses relating to COGS as operating expenses. In addition, there are non-monetary costs that are not included in a profit and loss statement that should be considered by management.  These hidden expenses are frequently ignored because they do not appear on either a P&L statement or a balance sheet.

When purchasing merchandise or materials that are used to produce sale inventory from countries beyond the borders of the USA, there are expenses, both direct and indirect that should be evaluated by management to determine if the all-inclusive costs will create more or less profit for the company. The purchase price may appear to be substantially less than if the goods were manufactured in the USA, but a buyer should make a comparative analysis, taking into consideration all the additional out of pocket expenses and the hidden, non- monetary, costs that determine the actual cost of the merchandise.

A complete evaluation of COGs and the value derived from purchasing goods should include the following:

Direct Costs

  • Inventory (buying inventory by container vs. buying small quantities as needed).
  • Freight (delivery by ship vs. air and scheduling deliveries to meet customers’ needs) – all readers of this article are aware of the current delivery timing issues.
  • Import Duties (this is a variable expense, determined by governmental policies).
  • Commissions paid to third parties for access to major retailers.
  • Storage and Handling Costs (warehouse vs. a fulfillment center – the proximity of storage to business operations; there may be additional shipping costs from warehouse locations to buyers).

Indirect Costs The indirect costs that appear as operating expenses are not allocated to the cost of goods sold. However, they may include line-item expenses that might not have been incurred if the merchandise was purchased within US borders or they may be included as a part of the general operating expenses.

  • Quality Control  A company may require a part-time employee as an agent at an off-shore manufacturing plant, during both the product development phase and during the time the merchandise is manufactured for shipment. Large companies often have a full-time employee hired for this responsibility, but the SME usually has to rely on an agent to oversee manufacturing. If damaged merchandise is shipped and has to be returned because of quality issues, the company can lose a market opportunity or even an entire sales season.
  • Travel Expenses

Management may travel to shop for the most favorable manufacturing resource. This will appear as a travel expense on a P&L.

  • Cost of Borrowed Funds

Most SMEs need working capital loans to cover the short-term costs of buying merchandise in large quantities since partial payment is usually required when placing the order, and the balance of the payment is due upon shipment.  These borrowed funds should cover the cost of purchasing the goods plus the time needed for payment from the end user. Large retailers request payment terms of 30 to 60 days following delivery. A growing company has to make certain they have working capital that allows them to cover their operating    costs while they await payment of invoices and, at the same time, allows them to purchase inventory for other customers.

  • Marketing Expenses

If the end user is a consumer, the company may decide to seek customers through online marketing in order to shorten the period of time for payment. A creative online marketing campaign is both time consuming and costly. The expense is reflected on a P&L statement as an operating expense.

  • Currency Exchange Rates

 This cost has to be considered in every purchase on a transactional basis.

Non-Monetary/Hidden Costs

  • Timing Delays: May result from quality control and shipping issues.
  • Management’s Time: The time spent overseeing importation issues; finding the best manufacturer, developing a good working relationship with that resource, and supervising the importation process and costs.
  • Indirect Borrowing Costs:There is an additional indirect cost of borrowed funds – the time needed to shop for the appropriate line of credit and the management of the borrowed funds.
  • Financial Management: Proper accounting procedures must be established. When financial management of borrowed funds is not properly supervised, the company may be forced to seek additional short-term funds from credit card companies. (Credit card debt should be avoided if a company wants to maintain its profit margins and maintain a strong credit rating.) Expensive short-term borrowing impacts profitability.
  • A competent CFO: One who evaluates the company’s capital needs, on a short-term and long-term basis, and tries to match the loan with these needs and also considers funding needs to meet the company’s planned growth strategy.

NOTE: The author serves as a financial consultant to SMEs in Miami Dade, Florida. When a company seeks working capital to purchase inventory, she guides them in evaluating the cost of goods sold (COGs) and assists them in preparing detailed cash flow projections. This exercise provides awareness of the dollars needed to meet financial goals. The preparation of realistic cash flow projections also forces management to realize that an increase in sales volume does not automatically increase profitability. SME’s should review their options and determine the best path to increase the bottom line of the company.

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