Running a small business, especially one birthed out of passion, can be exciting! The thing though is that if you are not on top of your finances, pretty soon, you can discover that it takes more than passion to keep the business running. You can start wondering why the business doesn’t seem to be making money in spite of all the time you are putting into it.
Keeping track of your finances is the first step to solving this problem. However, starting out, it can feel overwhelming. To help you get started, I created a Google Sheet you can use. Check out my YouTube video here where I walk you through it.
When you start tracking your finances, one term you might encounter is “Cost of Sales” (COS). While the term might seem complex, worry not! Let me break it down and also share some real-life examples to show how it helps you understand your business’s true profit.
Imagine you run a business:
For a product-based business, like say a bakery selling cookies or a business that sells T-shirts:
- You buy supplies (these are your direct costs).
- You sell the product (that’s your income).
For a service-based business, like say a digital marketing agency:
- You get a graphics designer who’ll do the work
- You pay for software licenses for the tools the graphics designer will use
- You pay for stock photography, fonts, etc.
- All the above are your direct costs
- You get paid for delivering artwork for a brochure (that’s your income)
Cost of Sales (COS) is simply the cost of those supplies you used to directly create what you sell. Think of it like subtracting the “making” cost from your income to see how much profit you actually make from selling.
Why is COS important?
- Better Pricing: Knowing your COS helps you price your product or service better. If you understand how much it costs to create them, you can price them to cover those costs and make a profit. A business can lose money by pricing its products/services wrongly.
- Efficiency Check: A high COS might mean there’s room for improvement. You might be buying things expensively compared to your competition, leading to higher prices. Some questions you might ask yourself – can I find ways to save on supplies or streamline my work process (maybe negotiate better deals with suppliers or reduce waste)? Tracking COS opens your eyes to this.
Let’s get into some examples to bring this home.
Product-Based Business Examples:
- Bakery: COS includes flour, sugar, eggs, and other ingredients used to bake cookies.
- T-Shirt Printing Shop: COS includes the cost of blank t-shirts, ink, and any materials used for printing designs.
- Clothing Boutique: COS includes the cost of wholesale clothing items purchased for resale in the store.
- Restaurant: COS includes the cost of food ingredients used to prepare dishes on the menu (flour, meat, vegetables, etc.).
Service-Based Business Examples:
- Graphic Designer: COS might be the cost of design software or specific materials needed for a client project (e.g., fonts, stock photos).
- Cleaning Service: COS could be the cost of cleaning supplies used for specific client jobs (detergent, sponges, cloths).
- Hairdresser: COS could be the cost of hair products used during client appointments (shampoo, conditioner, hair color).
- Auto Mechanic: COS includes the cost of replacement parts used to repair vehicles (oil filters, brake pads, spark plugs).
- Web Developer: COS might be the cost of specific software licenses or cloud services needed for client projects.
The key is to identify the direct costs directly tied to what you sell, whether it’s a product or a service.
A key thing to note is that you need to differentiate COS from business expenses. While it might sometimes be tricky to make the distinction, especially for service-based businesses, let’s see how to do it.
COS vs. Expenses: Don’t Get Confused!
- Think of COS as the ingredients for your product or the materials used for your service. These are directly used to create what you sell.
- Expenses are like the tools you use to run your business. This includes things like rent, utilities, salaries, marketing costs, and office supplies. These are essential for running your business but aren’t directly tied to each individual product or service sold.
So, Should You Track COS Right Away?
If you are still confused, take heart. It’s completely okay to focus on basic income and expense tracking initially, especially if you’re new to bookkeeping. The “Transactions” sheet in the Google Sheet I shared will help you with that perfectly!
However, if you’re curious about diving deeper and understanding your profit margins better, tracking COS can be a valuable tool.
Need Help Implementing COS in Your Business?
While this article provides a basic understanding, implementing COS effectively can involve specific considerations for your industry. If you’d like personalized guidance on incorporating COS into your bookkeeping system and maximizing its benefits, our team of experienced accountants is here to help! Schedule a 30-minute consultation to discuss your specific needs here
Remember: Understanding the basic concept of COS will give you a head start in managing your business finances effectively!