Permanent link for Estimating COGS on May 19, 2023

In planning for and tracking the cost of doing business, we often find that it's useful to divide the costs into two categories: fixed costs and variable costs.

Variable costs are the costs that increase with number of units sold. If sell twice as much, our variable costs roughly double. For example, if you were making a single iPhone, you would have to spend money for one screen and one battery pack. If you made two iPhones, you would need to spend twice as much to have two screens and two battery packs. Screens and battery packs are part of your variable costs.

A major component of variable costs is your costs of goods sold, or COGS.

Estimating COGS will help you understand your business' financial variability, guide you in pricing strategy, and provide a basis for establishing investor confidence.

COGS for Product-based Businesses

For product-based businesses, COGS are sometimes referred to as the production costs, and are expenses that are directly related to the production and distribution of your product. These costs can include raw materials, labor, shipping, and packaging. Understanding your production costs is crucial to determine how much money your startup needs to operate and become profitable.

Calculating actual COGS is pretty straight-forward:

COGS = Beginning Inventory + Purchases − Ending Inventory

(formatted equation)

For entrepreneurs looking to start a business, this takes a bit more work. To estimate your future production costs, you need to add up all the direct costs involved in producing your product. These can include:

1. Raw materials: the cost of materials that go into your product, such as components or ingredients.

2. Labor: the cost of the workforce involved in manufacturing or assembling your product. May sometimes include the portion of sales labor directly attributable to selling each unit of a product.

3. Shipping and handling: the cost of transporting your product to your customers or warehouses.

4. Packaging: the cost of materials used to package your product, such as boxes or bags.

Once you have calculated your production costs, you can use them to determine the price of your product and the minimum amount of revenue you need to generate to cover your costs.

For example, if your production costs for a unit of your product are $20, and you want to have a gross profit margin of 30%, you would need to price your product at:

Price = COGS / (1 - Profit margin)

(formatted equation)

Price = $20 / (1 - 0.30) = $28.57

This means that you would need to sell your product for $28.57 to cover your COGS and earn a 30% profit margin.

Knowing your production costs is essential because it can help you make informed decisions about pricing, product design, and manufacturing processes. By understanding your costs, you can optimize your production processes and pricing strategy to maximize profits and grow your startup.

COGS for service-based businesses

While the costs of goods sold (COGS) are typically associated with manufacturing businesses, service-based businesses also have costs that are directly related to providing their services. These costs can include wages, supplies, and overhead expenses, among others. Understanding your service-based COGS is crucial to determine how much money your startup needs to operate and become profitable.

To calculate your service-based COGS, you need to identify all the direct costs associated with providing your services. These can include:

1. Wages: the cost of paying your employees who provide the services.

2. Supplies: the cost of any materials or supplies used to provide the services, such as software or cleaning supplies.

3. Travel expenses: if your business requires travel to provide services, such as a consulting or delivery service, then you need to account for expenses like gas, car rentals, or airfare.

4. Overhead expenses: these are the costs of running your business that are not directly related to providing services, such as rent, utilities, and insurance.

As with production-based COGS, once you have identified your service-based COGS, you can use them to determine the price of your services and the minimum amount of revenue you need to generate to cover your costs.

Categories: entrepreneurship funding management
Posted by Thomas Hopper on Permanent link for Estimating COGS on May 19, 2023.