Cost of goods sold is an important number that helps calculate how profitable a business is. COGS is used as part of the equation to calculate a company’s gross income:
GI = Revenues – COGS
Cost of goods sold is also used to determine pricing and business profits. For example, COGS is used by businesses to calculate the gross margin for their business. This is done by dividing a company’s gross profit by its net income to get a percentage.
In our personal financial lives, we can look at the importance of cost of goods sold by using an example of providing a cake for someone’s birthday. A person has a range of options from baking a cake from scratch to ordering a custom cake. Each of these options will become progressively more expensive in cost, but also significantly less in terms of time invested. Baking a cake from scratch may be something that can be done for pocket change using ingredients that are already at hand. However, this will also require the biggest time commitment. On the other end of the spectrum, a custom-made cake may cost several hundred dollars. This is because the baker’s time is now included as part of the direct costs involved. On the other hand, this requires the least commitment of time.
Now let’s look at this example from the perspective of the baker. Let’s say it costs them $5 in ingredients and it takes them five hours to bake and decorate your cake. If their billable rate is $20 an hour, then the direct costs to them to bake you a cake will be $105. If they are working with an assistant, that charge could be even higher. This means they have to charge you more than $105 to make a profit.
If the baker’s cost of goods sold increases. Let’s say their supplier begins to charge them more for flour or sugar, they may look to find other suppliers who can bring their direct costs down. Otherwise, they will have to either agree to make less profit or increase the cost of their goods.
We also see a good example of the cost of goods sold in our retail purchases. It’s no surprise that retailers can use their purchasing power to drive down the cost of the goods that they sell. This is called buying the goods “at cost”. But because they are in business to make a profit, they must mark up these items to help generate enough money to pay their other expenses and still generate a profit. As consumers, we understand that this is why retailers can afford to offer drastically reduced prices of 60-70% off. Although they are still making a profit, it is reduced.