What is the Difference Between COGS and Business Expenses?
Classifying business expenses can be difficult for people who have just started businesses or those who are operating non-traditional businesses (e.g., SaaS, hospitality). One of the major sources of confusion is costs of goods and services (COGS) and business expenses. When discussing the profitability of a business, COGS is the most important. However, when you are looking at the health of a business, whether the revenue can cover the business expenses, and its future revenue projections.
What is COGS?
COGS is the cost of materials, production, shipping, and delivery associated with production and supply of goods and services to a company’s customers. These costs are necessary for the creation and delivery of the goods and services. COGS is used to determine the profitability of a business. If revenue is greater than COGS, then the amount remaining is the business’ profit. However, if COGS exceeds revenue, then the business is losing money on its goods because its revenue is less than the cost of producing the goods.
COGS may include:
- Raw materials
- Finished products
- Products under production
- Supplies incorporated into products
- Product containers
- Goods on display
If necessary for production and they can be tracked to specific products, these indirect costs are included in COGS too:
- Product Processing
- Product Repackaging
- Product Handling
- Administrative Expenses
What is Customer Success and How is It Classified?
Customer Success refers to the strategies and systems used by a company to ensure that its customers get the services/products they paid for, expect, and want. It can be used to gauge customers’ current level of satisfaction, unmet needs, customers’ preferences, and identify problems in the company-customer relationship. Moreover, it is often used to generate ideas for new products/services and ways to improve existing products/services.
If customer success is used to improve a specific service/product, then its cost can be attributed to that service/product. However, if customer success is used to get feedback and/or information on more than one product/service and/or the business overall, then it will be considered an operating expense, not a cost directly associated with a specific product.
Customer Success costs may include:
- Customers’ expectations
- Customers preferences
- Requested consultations
- Customer feedback
- Evaluation of customers’ relationships with the company
COGS and Service Companies
COGS is not the appropriate term to use for service companies (e.g., Zoom, Mailchimp, Spotify, Dropbox). Instead, service companies use the phrase cost of services (COS) or cost of revenue (COR). For example, software as a service (SaaS) companies do not have the same production costs as companies that actually produce a product (e.g., computers, chairs, cars). Their costs must be looked at from the perspective of what is necessary to produce the service that is being delivered to a company’s customers.
COS may include:
Third-party software costs
Professional services (e.g., consulting, implementation, data migration, training)
Employees costs directly associated with software operation, delivery, maintenance, and the systems required to do those things
What are Operating Expenses?
Business expenses are the costs indirectly associated with the production of goods and services. These are expenses that cannot be directly tied to the manufacturing, supply, or delivery of goods and services to a company’s customers. Moreover, their useful life is less than 12 months. Business expenses may include office supplies, electricity, sales and marketing, and customer service.
Although it is true that the business must pay these costs in order to produce its goods and services, if the costs of these items are spread over the business’ activities, then the business must treat them like general administrative costs or general business expenses that must be paid in order for the business to function. If a business lacks enough income to cover its business expenses, then the business may be experiencing cash flow problems, be in the process of developing its revenue stream, or be having some problems attracting customers or managing its operations.
Operating expenses may include:
- Employee wages/salaries
- Employee benefits
- Employee training
- Workers’ compensation
- Mortgage payments
- Property taxes
- Business insurance
- Property insurance
- Health insurance
- Legal fees
- accounting/bookkeeping fees
- Management software costs
- Sales and marketing
- Sales commissions
- Customer success costs related to upselling
- Research and development costs
- Business organization membership fees (e.g., chamber of commerce, trade organizations)
What are Capital Expenditures?
Capital expenditures are the costs associated with purchase, maintenance, and depreciation, and disposal of physical assets. Assets that are considered capital expenditures include property (e.g, buildings, land), equipment (e.g., machinery, vehicles, office furniture), hardware (e.g., computers, laptops, telecommunications), and software (e.g., CRM, ERP, cybersecurity).
These kinds of assets will be used for more than a year. Since they are long-term assets that provide ongoing benefits to the company (as a whole), their costs cannot be included in the COGS/COS or as operating expenses.
What is the Connection Between COGS, Operating Expenses, and Capital Expenses?
COGS, operating expenses, and capital are business expenses. They can all be deducted from a business’ income, and, ultimately, reduce its taxable income. Moreover, COGS are deducted in the year in which they are incurred, whereas operating and capital expenses can be deducted in the year incurred or deferred until later. In some cases, the expense can be 100% deducted in a year.
When calculating the profitability of your business, the overall health of your business, and doing revenue projections, it is important that business consider the correct costs. Failure to disclose costs that affect the profitability of their operation and economic health of the business is considered fraud. Furthermore, this information is needed when compiling data for mergers, acquisitions, loans, stock issuance, industry comparisons, and bankruptcy proceedings.
Since brick and mortar businesses have different costs than online businesses, and product-based businesses differ from service oriented businesses in their cost structure, it is important to correctly classify the expenses directly and indirectly related to the functioning of your business and its production.
There are no Generally Accepted Accounting Principles (GAAP) that apply to COGS and COS. Consequently, there will be times when you may be uncertain of how to classify an expense and how to treat the deduction (e.g., straight line, accelerated). In these instances, it is best to consult with financial professionals who have experience working with different accounting systems and the IRS. In short, it is fairly easy for you to correctly compile your financial documentation, file your taxes, and expense your business costs.
The Free Cash Flow (FCF) Agency can help you with this and other accounting issues. Contact FCF to find out what it can do for you.