FINANCIAL MODELING 101: COGS

The Cost of Goods Sold (“COGS”) in financial modeling is linked to the revenue generated by the firm. When building a financial model, it’s important to keep track of all expenses that contribute directly in generating revenue. Mistakes surrounding COGS and linking the expenses directly related to producing a product or service to revenue are common among new analysts.

The most basic formula for COGS is adding the beginning inventory and purchases minus the ending inventory. This formula is used routinely in retail, but it can differ business in the service industry or IT. In the service industry, such as a design firm or consulting business, COGS is commonly labeled Cost of Revenue. Salaries are usually not included unless they are directly related to production of the goods or service.

 Below are a list of common COGS line items and how to incorporate them in your financial model.

Common COGS Line Items:

·      Sales Commissions – whenever you have sales commissions as part of your business model the commissions expensed after each sale should be included in COGS.

o   Financial Model – you will sometimes see sales commission expensed as a cost of revenue between gross revenue and net revenue. However, commissions should be included as COGS if they are going to sales reps that generated the sale.

·      Raw Materials – any materials that are purchased to produce the product or service. You should include laptop’s or IT hardware that directly contribute to the production of the good or service. Software that’s purchased to build or design the product should be included as well.

o   Financial Model – it’s important to take into account all the materials that contribute to the production of a product or service. You have to dive into the business model and gain an understanding of how the business operates to figure out the different materials required.

·      Inventory – The most common COGS is inventory and it’s the easiest to calculate.

o   Financial Model – you need to know beginning inventory and add that to the inventory purchased in the same time period and then minus the ending inventory. If you want to build a simplified model you can take the average cost of inventory sold and use that to calculate COGS.

·      Shipping Cost, Printing, Direct Labor, etc. – If you need to ship the product to customers, print labels or hire labor for a specific function related to production all of these expenses are included as COGS.

o   Financial Model – These other costs can be tricky to incorporate in a forecast, but they can be calculated by tracing the steps it takes for the product to reach the customer and for the firm to recognize revenue.

 Once you know your COGS or Cost of Revenue you can start to analyze the true cost per unit sold and gross profit per sale. Keeping track of COGS and managing related expenses are key to the long-term success of any business. Envol Capital has built detailed forecasts and financial models for a variety of industries. We spend the time and resources to understand our clients so we can provide analytics that can have an immediate impact on operations. Please contact us today if you’re interested in selling your business and want us to perform valuation services, as well as find a qualified buyer. We also work with companies looking to make strategic acquisitions and investments across multiple industries.

 

Deepak Kumar