How to See Your Real Value Using Cost of Goods Sold (COGS)
February 19, 2016
Wouldn’t it be nice if you could easily see the monetary value of the products or services you sell? Well, you can. Enter: COGS.
An Overview of COGS
COGS is not just another complicated accounting term that’s on your tax forms, it’s actually fairly simple to understand (and you can record them in FreshBooks).
COGS stands for Cost of Goods Sold. This means that for something you sell, COGS is the cost that directly went into that revenue.
It’s easier to explain for a product: COGS are the materials and costs needed to create that product. For example, the iron needed to make steel and the cost to get that iron to your factory.
For a service, it’s a little more complicated.
Luckily, the same logic applies because services are the items or services you resell (or re-bill) to your clients. For example, if you hire a contract web designer to help you design a website, and then re-bill their hours to the client, this is a COGS for you.
What Doesn’t Qualify as COGS?
It’s simple: every other expense is not a COGS.
For example, the salary you pay to your marketing or administrative employees isn’t COGS because they are paid at a fixed rate that does not vary based on how much your business sells. The same goes for rent, utilities, and advertising.
Asking yourself a couple of questions is a good way to determine whether it qualifies as a COGS or not:
- What expenses would I have, even if I didn’t make any sales this month?
- Which of my staff directly contribute in revenue-building services?
And if you’re still not sure, check with your accountant. They’ll be able to give you some qualified advice that a simple blog post can’t.
The Purpose of COGS in Your Business
COGS eliminate the value that your business did not contribute, which in turn allows for your statements to only show the additional value you or your company is adding. In the above case, the value to the end client from you is work you did above and beyond the contract web designer. Therefore, only the incremental value counts towards your revenue, not the COGS of your revenue.
The Importance of COGS
COGS are important to be removed from your revenue so you aren’t taxed on them or added in to misrepresent your margins.
This is why on taxes forms and financial statements, COGS appear on a separate line item and seemingly reduce your revenue.
You also cannot be taxed on them as it would result in double taxation (the web designer you hired will be taxed as part of their income).
How to Handle COGS in Freshbooks
FreshBooks handles COGS in two ways.
First, any expenses you log and re-bill to your clients, such as the contracted web designer above, is recorded as a COGS.
The second workflow is to assign certain categories of expenses as COGS. This is especially important if you’re not re-billing all your COGS.
You cannot edit a top-level category list and categories in FreshBooks. HOWEVER, you can add and edit categories in sublevels of the hierarchy list.
To do this:
- Navigate to the Expenses section of your account.
- Click on New Expense.
- Under the category drop-down menu, select a category to open up the secondary list.
- Click on the edit this list.
- Click on add subcategory. Your new subcategory expense will now be on your list!
One more quick step and you’re ready to go.
You need to assign the categories to Cost of Goods Sold (COGS) on your Profit and Loss report in FreshBooks.
- Open your Profit and Loss in the “Reports” Tab
- Click “edit” beside “COGS” under Sales/Income
- Assign the categories you created to “COGS”
- And you’re done!
Now, if you’re using FreshBooks to record your COGS, you can easily deduct them for next tax season (or scramble to assign them all in this year via the CSV Expense Import).
If you’ve learned something in this article, make sure to click the share button. I’d love for every freelancer and small business owner to understand COGS and how to use them. But that can only happen if awesome people like yourself are willing to help spread the word.