Understanding Cost of Goods Sold for Service Businesses

Why it is important for a Service Businesses track COGS, by Bob Carstens, CEO, FinancialSoft, Inc.

We have many service company clients and we have occasionally observed that these companies neglect to make entries in their QuickBooks for “Cost of Goods Sold” (COGS) or, “Cost of Sales” (COS). As we hope to make clear in the article below, service companies DO have COGS and it is very important that they are accurately recorded.

Cost of Goods Sold (COGS) is a major element in determining a company’s Gross Margin. Why is it so important to understand Gross Margin? Here are some of the reasons:

  1. Gross Margin identifies how much money a company has to cover expenses.
  2. Understanding Gross margin helps you compare your company to the completion.
  3. Gross Margin is the basis for pricing.
  4. Gross Margin will show how efficiently your company is running.
  5. Note: Your FinancialSoft reports compare Gross margin to your industry peers.
  6. You cannot use the fixed and variable cost impact analysis tool (Break-even) within your FinancialSoft report without variable costs, which are COGS.

 

COGS Pic

COGS is usually the largest element in Variable Costs. Variable Costs (VC), and therefore COGS, are an important element in all of FinancialSoft’s reports and understanding them is essential for business planning.

Many service businesses do not believe they have Costs of Goods Sold or at least that it only includes material expenses. Cost of Goods Sold (COGS) is also the same as Cost of Sales (COS). Unfortunately QuickBooks does not have a category for COS, so service centered businesses should simply treat their COS as COGS in QuickBooks.

In a service business, Cost of Sales is dominated by the labor provided to the customer for the company’s services. If a company has employees that are salaried or paid hourly, the time they spend working for the customer versus doing other things is very important to measure. A good example of a company that is primarily a service business is a law firm. A law firm’s life is centered on “Billable Hours”. They absolutely have to track the hours an attorney spends on each client in order to bill them correctly. I am sure some of you remember the Book “The Firm” about a law firm that eventually went under because they over charged the clients with padded hours not spent on the client’s case.

If your business charges for your services by the hour, the time spent providing the service absolutely has to be tracked in case a client challenges your charges. If your services are provided as a flat rate, you will still benefit from knowing the exact time spent performing that service to insure profitability, as well as measuring the efficiency of your employee that performs the service.

We have worked with the Veterinarian Practice industry helping them find solutions to their accounting challenges. Because they do not deal with insurances like human doctors, their pricing is critical to their survival as animal owners do shop around for the best prices as the entire fee will come out of their pocket. This industry historically did not track hours that the doctor spent with the patient versus time they did not. As a result, they struggled to determine how to price their services for various procedures. A software company sponsored by a veterinary pharmaceutical company, has developed software that basically is a time card system that has the doctor log the time they spend with a patient. The software calculates, based on the doctor’s salary and time spent with the patient, reasonable pricing for their services. One of the side benefits was that the veterinary clinics were now able to measure doctor efficiency. Now that the doctors logged their activity time, they could now see which doctor was generating the most hours working with patients rather than doing other things. It helped the administrators set appropriate salaries for their doctors (their biggest expense) as well as helped motivate doctors to generate more time for patient activities.

Even when I was a salaried engineer working for a large publicly traded company, we tracked our time spent on each project. It only took a few minutes a week to fill out a time card. Today, there is software that is economical, easy and fast to use that will automate the process – only requiring a few minutes a day to track time for your employees that work with customers.

Tracking and reporting in your QuickBooks your COGS or COS will help your company in so many ways. The time and any additional expense incurred will have a great return on that small investment.

 

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