5 Ways Accurate COGS Helps Improve Profitability

Accurate Cost of Goods Sold (COGS)  helps improve profitability by giving you the information needed to make pricing decisions that grow revenue over expenses, so you can focus your time on cutting costs and creating a better experience for your customers.

With accurate COGS you’ll know the exact cost of each item you sell and be able to separate that from the fixed costs in your business. Once done, you can analyze how changes in volume impact your profit since the COGS and revenue will change with volume, but the fixed costs won’t. It also shows you how a little reduction in the cost of each item can add up to a big boost for your bottom line.

Below you’ll find five ways that accurate COGS helps you make the right business decision to improve profitability:

• Increasing or decreasing prices to make more profit
• Deciding whether to give volume discounts
• Comparing growth options
• Prioritizing cost-cutting efforts
• Targeting profitable customers

Increasing or Decreasing Prices to Make More Profit

An accurate COGS is important when you are deciding if you should increase or decrease prices to become more profitable. It lets you evaluate the impact of the price changes because of how price and sales volume relate to each other and factor into your gross profit :

• Sales volume depends on the price. While there are exceptions to the rule, higher prices will make sales volume decline and vice versa.
• Revenue = Price per Item * Sales Volume
• COGS = Cost per Item * Sales Volume
• Gross Profit = Revenue – COGS

Price increases may make sales volumes decline, and a decline in sales volume lowers COGS. Whether gross profit increases or decreases depends on the changes to revenue versus the changes to COGS.

For example, you sell 1,000 handmade candles per month for $10 each and your total expenses are $7,000. This gives you $3K in profit. Now it’s time to evaluate the impact of raising the price by 10% where volume drops by 10%, versus cutting price by 10% for a 10% lift in volume.

With accurate COGS, you know that each candle costs $5, so total COGS is $5K and other expenses are $2K. With this information, it becomes easy to compare options:

Raising the price is your best option as you’ll make an extra $400 per month even with the volume decline, whereas you would have lost money if you cut the price to $9.

Deciding Whether to Give Volume Discounts

Accurate COGS also lets you do a similar analysis when customers want to place a big order at a volume discount. If you’re negotiating with a big housewares retailer that says they’ll buy everything you can make if you give them a 30% discount, and you can produce 2,000 per month, should you do the deal?

While a larger order volume for a 30% price decrease sounds tempting, it would hurt your profitability. Selling 2,000 candles at $7 each would be $14,000 in revenue but your COGS would be $10,000. After your other expenses of $2K you’d only make $2K in total profit which is $1,000 worse off than you were before. You should definitely not do that deal.

Here’s how COGS can help. By knowing the cost of goods sold, you determine that by hiring another worker for $1,000 per month, you could produce 3,500 candles total and make the deal work for you.

Without knowing the accurate COGS in this situation, you run into 3 potential problems:

• You don’t know what profit is going to be.
• You could make the error of overestimating profit by forgetting to increase product costs.
• You could overestimate costs and miss out on the deal by increasing all expenses in proportion to the increased volume.

Here’s a quick look at how having an accurate COGS lets you find the solution that improves profitability, while not knowing can lead to the mistakes mentioned above.

Comparing Growth Options

Having an accurate COGS also lets you compare options to boost profitability as your business grows and has multiple pathways forward. One example is hiring a manufacturing team versus getting an equipment financing loan to buy equipment and automate manufacturing for the candles.

Start with these details:

• Raw materials per candle cost $5.
• For each manufacturing person you hire at $1,000 per month, you can make 1,500 candles.
• Office rent costs $1,000 for enough space for 5 people to make candles.
• Your original $2,000 of other expenses remains the same.
• With the equipment, you can make 12,000 candles with only 1 manufacturing person and only need a single office for $1,000.
• The equipment costs $3,000 and you can get a loan for the purchase price at 10% interest for a 1-year term.

Here’s how accurate COGS helps you determine which option boosts profit on your income statement the most.

Getting the equipment loan improves your profitability by $3,384.52 over the manufacture-by-hand option.

Taking this analysis one step further, accurate COGS shows that you can hire 2 more people before you have to get another office. Here’s how that changes your income statement.

The additional 2 people would get you a higher profit but still leave you $584.52 below the equipment option.

Prioritizing Cost-Cutting Efforts

Accurate COGS helps focus your time and effort on how to make the biggest impact on profitability. If you have only enough time to negotiate with either your landlord or your raw materials supplier, which one do you choose? Accurate COGS from the equipment loan option from above shows you’ll get a much bigger savings from a small 2% discount on materials ($1,200 savings) than a big 25% discount on rent ($250 savings).

You can get an extra boost to profit by negotiating payment terms along with the discount. If you can negotiate payment terms of net-45 along with the 2% discount, and if your customers all pay net-30, then you’ve effectively created a 2-week, interest-free loan. And you could put the extra funds into a savings account earning 3% and make around $96 extra profit in those 2 weeks.

Targeting Profitable Customers

Many businesses miss out on improved profitability from accurate COGS because they bucket all the customer-specific costs together instead of prioritizing the most profitable customers. This is especially true for service businesses that don’t track COGS because the IRS doesn’t require it for their business.

Here’s an example from a software services company where the company has 3 different pricing and product tiers:

• 500 customers in the Basic Tier for $10,000
• 275 in the Advanced Tier for $30,000
• 50 in the Enterprise Tier for $100,000

Without accurate COGS, their income statement looks like this:

It’s a great business, but since they can’t distinguish between customers, they don’t know what the best growth strategy will be. They might choose to focus on advanced customers because that’s what drives the most revenue, but tracking accurate COGS across their customer base would change their decision given these facts:

• Each customer costs $10 for finance billing, regardless of tier.
• Customer success reps cost $95,000 and can handle 25 Advanced or 10 Enterprise customers (Basic gets no customer success rep).
• Marketing costs are $10 per customer for Basic and Advanced and $100 for Enterprise.
• Inside sales people cost $60,000 and they need 1 Advanced Tier customer per 25 customers. Outside sales people cost $200,000 and they need 1 Enterprise customer per 10 customers.

Now the software company can track accurate COGS by customer tier and figure out where to focus future resources. Here’s how their income statement changes:

Now they can see that Enterprise customers are 7 times more profitable than Basic, and about 3 times more than Advanced, and they can make strategic decisions on how to approach their efforts going forward.

Tracking accurate COGS gives you the needed insight to prioritize your efforts and make the right business decisions for improved profitability.