Gross profit and cost of goods sold are accounting concepts that translate into real-world strategies for improving your bottom line. They reflect the expenditures that you make every time you manufacture a product you will sell or buy an item that you will resell. Because these numbers affect every transaction you make, improvements in these numbers can have far-reaching consequences for making your business financially sustainable and helping you reach your personal and professional goals.
Production systems and shrewd purchasing affect gross profit and cost of goods sold.
The traditional formula used to calculate cost of goods sold is:
Starting inventory + new inventory purchases - closing inventory = cost of goods sold
This formula shows you exactly how much you spent on materials during a given period by including items that you purchased beforehand but hadn't yet used when the accounting period started and factoring out materials that you purchased during the relevant period that you still have on hand.
This cost of goods sold formula is relatively simple for retailers who buy goods and resell them, but it is more complex if you manufacture items from raw materials. If you are a manufacturer, your cost of goods sold account in your accounting system should also include the dedicated labor that went into producing your products. In that case, the inventory figure that you include in the equation will be the finished inventory of items you have produced rather than your inventory of raw materials waiting to enter into production.
For a manufacturer, labor costs in the cost of goods sold formula include actual hands-on production time and do not include any of the other labor costs that your business incurs as it operates. Labor costs not included in the cost of goods sold are management payroll, human resources hours, sales salaries or in-house cleaning and maintenance expenses.
It can be cumbersome to track cost of goods sold labor and separate it out from your overall labor accounting, but doing so can help you to get a clear picture of whether your production systems are cost effective and whether they will bring you a healthy profit as your sales get to scale. If you manufacture shoes and it costs you $50 in labor to manufacture a pair that you sell for $75, your business may not ever become profitable no matter how many shoes you make and sell.
Tracking labor costs associated with the cost of goods sold also brings you into a world of gray areas because many employees, especially in smaller companies, don't devote all of their time to a single activity. Production staff may do deep cleaning on equipment when demand for products is down, and managers may step in and help with production to meet a tight deadline. These fuzzy lines between production and other work activities shouldn't deter you from tracking your cost of goods sold labor as accurately as you can. The numbers you gather will still be useful even if they aren't absolutely precise.
- Cost of inventory. If you pay more for raw materials and items you purchase for resale, you'll experience an increase in the cost of goods sold and a corresponding decrease in gross profit.
- Production systems. The better your production systems, the less you'll spend on labor dedicated to the cost of goods sold, improving your gross profit and leaving more for other operating expenses and your own income.
- Prices. Even if your cost of goods sold is high, you may still earn a healthy gross profit if you charge your customers enough to cover these fundamental expenses.