Cost of goods sold vs operating expenses

As one of the more common bookkeeping questions we hear, the difference between Operating Expenses (OE) and Cost of Goods Sold (COGS) is a fairly straightforward one, but it plays a significant role when it comes to allocating and analyzing the resources you spend to make your business profitable. 

While both OE and COGS are considered expense accounts from a bookkeeping point of view, they’re separated on the income statement to differentiate between money that’s spent to keep your company running, and money that’s spent to directly support the costs associated with providing your company’s product or service. In the case of a service industry, the term Cost of Sales (COS) is often used rather than Cost of Goods Sold since there are no physical goods involved, but for the purposes of this discussion, we’ll be using the generic term COGS.

Understanding the difference between regular operating expenses and COGS begins with recognizing two important facts:

1. The terms "expense" and "cost" don’t always mean the same thing.
2. All expenses are not created equal.

Expenses vs. Costs

An expense is a cost of doing business, but a cost is not necessarily always an expense. The easiest way to illustrate the difference between these two terms is to look at a simple example.

Let’s say your company sells souvenir widgets to passing tourists from a truck on the street. You have a pretty good idea of how many widgets you usually sell in a day, but you never want to risk a lost sale, so you always buy a few extras when you purchase your supplies each morning. If you spend $500 on today’s batch of widgets, but you only end up selling $400 worth of them:

• the cost of your widgets is $500;
• $400 of that amount constitutes an expense; and
  
• the remaining $100 constitutes an asset.

From an accounting point of view, an expense is something that’s used up, or consumed, during the normal course of your business operations. The $100 worth of widgets that you didn’t sell today, while still representing a cost to your business, won’t become an actual expense until they’re sold on some other day.
Don’t get too hung up on the name. Any business cost directly related to the sale of your product or service becomes an expense once it’s been allocated to a sales transaction, even though it’s still referred to as a cost of goods sold.

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Direct Expenses vs. Indirect Expenses

Every business has operating expenses, but whether or not those expenses can be classified as COGS depends on whether or not they’re directly related to the sale of a product or service. The terms direct and indirect are often used to differentiate between money that’s spent to:

• fund the purchase or manufacturing costs of goods or services being sold – such as raw materials or inventory, packaging, sales or manufacturing labor, or shipping (direct);
  
• keep a business running – such as rent, insurance, utilities, or administrative wages (indirect).
  

One way to figure out which is which when it comes direct and indirect expenditures is to ask whether they would still be considered an expense even if a sale had not occurred. If the answer is no, as it would be for the purchase cost of our vendor’s widgets, then they probably fall into the direct, or COGS category. If the answer is yes, as it would be for the insurance on our widget-vendor’s truck, then they’re most likely an indirect operating expense.

Tracking Your OE and COGS

So where does all of this land us when it comes to managing our books? If you outsource your bookkeeping, you can simply let someone else worry about the answer to that question. But for the sake of staying in the loop where your business accounts are concerned, the basic entries would look like this:

• When you incur an indirect expense, such as rent or insurance, your bookkeeping entry would debit the appropriate expense account and credit accounts payable.
• When you incur a direct cost, such as inventory, your entry would debit the appropriate asset account and credit accounts payable.
• When inventory is subsequently sold, it becomes an expense, so your entry would credit the asset account and debit its correlating COGS account for the same amount.

Tally Solutions | Updated on: August 23, 2022

• What is COGS?
• COGS for a company that sells physical products
• COGS for a company that sells services
• What are operating expenses?
• OPEX for a company that sells physical products
• OPEX for a company that sells services
• COGS vs. OPEX: why they matter to every business
• Business management software for in-depth insights

COGS is short for the cost of goods sold and is also known as the cost of sales or the cost of revenue. COGS is the value that represents all the costs that are linked to the production or manufacturing of the goods and services that you sell to your customers. It does not take selling, general, and administrative expenses into account and also does not include interest expenses in its calculation. COGS is an important metric that your business should pay attention to. This is mainly because the cost of sales shows you at what cost and how well you are able to deliver goods and services to your customers.

Vertical Profit & loss A/C in TallyPrime

A cost of sales formula used to calculate the cost of goods sold is as follows.

Cost of sales = Beginning inventory + Purchases – Ending inventory

Let us see how it works with an example. DogBark Ltd. had $50,000 worth of inventory in September 2021. By the end of the month, it had $5000 worth of inventory left with the business. In the same month, it incurred several expenses that were directly related to the production of the product it sells to its customers online. Let us say that DogBark spent $1,000 on the packaging, $5,000 on salaries, and $200 on delivery.

You can calculate the purchases first which are $1,000 added to $5,000 plus $200 which equates to $6,200. Now using the formula and plugging in the values, we arrive at $51,200 by adding $50,000 with $6,200 and then subtracting by $5,000. The COGS for DogBark is $51,200.

It can get confusing to figure out what to include and what to exclude from the COGS calculation because different businesses operate differently. A simple way of figuring out what to include and what to exclude can be determined by the effect of an expense on the production. Any expense that you must pay otherwise the manufacturing will come to a stop should be included. All other expenses won’t be included. For example, the cost of packaging, storage costs, wages, and raw materials must be included in the COGS calculation. You should exclude the commission you pay your employees, product development costs, and overhead costs.

COGS for a company that sells physical products

For a business that sells products, calculating the COGS is a much easier and smoother process. You need to calculate and add all the costs that went into making the final product. These include the raw materials you use to manufacture the product and the labor costs associated with manufacturing the final product. The COGS calculation will also include the costs that are associated with the product reaching your customer. If the product needs to be shipped to your customer, then you will include the shipping costs in your final calculation.

COGS for a company that sells services

If you are a business that provides services then it might be a little difficult to calculate COGS because you are not dealing with manufacturing costs such as raw materials and components. But you are going to include the costs that you incur in providing the services to your customers. If you are providing a digital service then you are going to include the hosting charges in the cost of goods sold calculation. Let us say you run a coaching center where you have several experienced teachers. The COGS calculation will include the teacher salaries depending on how many hours they work for each day.

What are operating expenses?

COGS vs expenses are two different concepts even though they might appear to be the same on the surface. Operating expenses are also often referred to as OPEX are the costs incurred by your business in the process of producing goods and services. OPEX is also known as an expenditure. Operating expenses are important for creating an annual plan for your business because it matters in budget allocation for production and delivery phases. OPEX shouldn’t be confused with overheads because operating expenses won’t be incurred once production halts. Overhead costs go on even if business production has stopped. Examples of operating expenses include packaging, materials, machinery, and labor.

OPEX is different from capital expenditure or CAPEX. Operating expenses exclude acquiring costs. If you are moving to a bigger building because your business has expanded, then these expenses will come under CAPEX rather than OPEX. This is because the expenses are not directly linked to the production of the final product or service. What truly differentiates CAPEX and OPEX is the value. When you invest in an asset, it adds value to your business as opposed to just allowing you to run your operations. CAPEX is included in your statement of cash flows rather than with your operating expenses.

The operating expenses ratio or OPEX ratio is a vital ratio calculated by businesses to find out how much expenses are incurred compared to the net sales. This ratio can indicate whether you are succeeding in keeping expenses as low as possible while selling more or not. The OPEX ratio is calculated by adding the operating expenses with the cost of goods sold then dividing the sum by net sales. If your operating expenses are high compared to net sales, then it means you must look for ways to decrease your operating expenses so those expenses are not eating away your net sales.

OPEX for a company that sells physical products

The difference between COGS vs expenses will be clear with an example of a company that sells physical products. Let us say you operate a bakery and you incur expenses along the way which are operating expenses. You have rented the shop which is right beside a major road. You post your ads on your Facebook page, Instagram, and Twitter. You have business insurance. You pay wages to those who deliver orders to customers’ homes. You are required to pay for the maintenance of the equipment you use. You pay for the cleaning supplies and you pay for the training of new employees. All of these are included in the operating expenses.

OPEX for a company that sells services

COGS vs expenses will be clearer with the help of another example, this time a business that provides services. Let us say you have a coaching center. Your operating expenses will include the banners or advertisements that you put out to get students enrolled. It will include the rent you pay for the building where the coaching center is located. The operating expenses will include the employee salaries except for those who are teaching. For example, the salaries of HR, legal, sales, and marketing departments will get included in the operating expenses. The operating expenses will include CRM, office utilities, and insurance too.

COGS vs. OPEX: why they matter to every business

COGS and OPEX are insightful for every business because they show you the current state of your business. They both let you know if you are spending way too much on expenses and when changes need to be made. Any business needs to sustain itself and ensure that it is able to earn higher than what it is spending. For startups and small businesses, the story might be different initially when they are finding their footing in their industry. However, over time it is imperative that businesses understand their operating expenses and costs of getting goods sold to ensure they are making money instead of spending more.

COGS enables businesses to understand their efficiency levels in manufacturing a product or service. Are you able to have a high gross profit from selling a particular product? Or is the product becoming more expensive to manufacture? Some products might be bringing in the cash into the business but if they are too costly to manufacture and their cost is likely to become more expensive in the future, then it might be time for your business to change its course. Your business needs high profits because you should be able to afford your operating expenses at the very least. The only way to ensure lower costs is to think of ways where you can save such as negotiating with a supplier.

OPEX lets you discover how well you can manage running your business. They show you if you need to take matters into your own hands and cut down spending on everyday tasks. For instance, many businesses resort to halting their hiring for some time if their operating expenses are going through the roof. Other businesses choose to cut down on facilities that aren’t mandatory at their business premises. As a business, you need to be aware of both the operating expenses and cost of goods sold to get a better picture of your business efficiency so changes can be made sooner rather than later.

Business management software for in-depth insights

A business management software such as TallyPrime provides deep insights and empowers you to manage your business with ease. It can be used by growing businesses, startups, and even enterprises. TallyPrime is an accounting software solution with ERP capabilities that gives you the ability to integrate your business finances and be on top of the game. It has superb report generation capabilities so you can get detailed analysis of any aspect of your business when you need it. The round-the-clock access, security features, and features such as inventory management ensure you can manage different aspects of your business.

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