One question frequently asked by our CFO services clients at Small Business Accounting Inc. is, what sets apart the Cost of Goods Sold (“COGS”) from Operating Expenses (“OPEX”)? These terms involve spending money to keep your business operational, but are they interchangeable? Let’s delve deeper into their differences and why understanding them matters.
COGS: Bringing Your Product to Life
Cost of Goods Sold (COGS), also known as Cost of Revenue (COR) or Cost of Sales (COS) in service-oriented businesses, encompasses the expenses your company incurs to create and deliver its products or services. This includes all costs associated with the production and delivery process but excludes indirect expenses like marketing or facility rent.
For businesses selling physical products, COGS is straightforward and consists of raw materials, manufacturing labor, and shipping costs. In the case of service-based businesses, the concept remains the same: any costs incurred in providing services to customers fall under COGS. For instance, a coaching service would include employee payments for service delivery, and for digital services like SaaS, web hosting costs would be part of COGS.
Let’s consider a couple of examples:
COGS for a Company That Sells Physical Products: Sample Bread, a bakery, sells a variety of baked goods both in-store and online. Their COGS includes expenses such as baking ingredients, wages for bakers, packaging, and shipping costs for online orders.
COGS for a Company That Sells Services: Sample Learning, an education-tech company, offers online learning tools. Their COGS includes payments to on-demand tutors, consulting fees for teachers involved in pre-recorded lessons, video production agency costs for producing lesson videos, and AWS hosting expenses for their app.
Operating Expenses: Keeping Your Business Running
COGS addresses the direct costs of creating and delivering your products, which form the core of your business. However, running a business involves more than just production and sales. Workers need facilities to work in, marketing efforts to attract customers, and administrative tasks to manage. These indirect business overhead costs are classified as Operating Expenses (OPEX).
OPEX includes categories like facilities costs (rent, utilities, perks), marketing and sales costs, business insurance, administrative expenses (legal fees, finance help), and headcount costs for employees not directly involved in goods/services creation and delivery.
It’s important to note that OPEX doesn’t cover costs related to asset acquisition or investments, which are classified as capital expenditures (CAPEX). CAPEX costs are distinct and are listed separately on financial statements.
Let’s look at examples of OPEX:
OPEX for a Company That Sells Physical Products: For Sample Bread, operating expenses include rent for the bakery, utilities, cleaning supplies, maintenance fees for baking equipment, wages for retail clerks, salary for the general manager, various insurance costs, employee training, and fees for bookkeeping, tax, and payroll services.
OPEX for a Company That Sells Services: Sample Learning’s operating expenses encompass rent for the HQ office, salaries for non-production employees (marketing, sales, HR, finance, management, etc.), business and rental insurance, utilities for the office, employee amenities, advertising costs, administrative software licenses, and fees for bookkeeping, tax, and payroll services.
Why the Distinction Matters
Understanding the difference between COGS and OPEX is crucial as they provide unique insights into your business’s health. COGS directly affects your profitability, as it reveals how efficiently you create your product. If COGS is high relative to revenue, you might struggle to cover operating expenses, hindering overall profitability.
By analyzing COGS, you can identify areas to improve efficiency, such as renegotiating supplier contracts or investing in training to increase productivity without raising costs.
On the other hand, OPEX reflects your business’s overall efficiency in day-to-day operations. High OPEX can lead to cash flow issues, but analyzing these expenses allows you to optimize spending. Reducing marketing expenses, facility costs, or refining hiring plans are common strategies to lower OPEX.
In conclusion, COGS and operating expenses provide distinct and essential information about your spending and business health. Utilize both to gain a comprehensive understanding of your expenses and ensure you’re getting optimal value for your investments.
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