As stated in an earlier blog we at FinancialSoft have found some very interesting accounting errors when running our reports. Many of them are not data entry errors but reflect misunderstandings of accounting practices.
Many of these accounting errors cause issues in the metrics that we measure in Electronic Financial Officer as most of the metrics are ratios. Ratios are represented by one number being divided by another. So if the ratio has a denominator that is zero that will cause an error in the metric. One of the elements Electronic Financial Officer reports divides by is cost of goods sold or COGS. COGS are used to determine the company’s number of days of inventory and the number of days of payables.
What we found interesting is that many companies think they operate with no cost of goods sold. Cost of goods sold represents the costs it takes to provide the product or service. In our experience we have yet to find a company that truly has no cost of goods sold. Let me cover several types of businesses so you can understand why we do not believe any company has truly zero cost of goods sold.
Cost of goods sold is the easiest to determine in a business that sells physical goods like a Product Business. In any product business there always costs associated with the item that you are selling. The company either purchases the item or manufactures the item with materials that they must purchase. These purchased items are all costs of goods sold items. In addition, any labor and direct activities to deliver that product to the customer are included in cost of goods sold. Even a distributor or retailer clearly has cost of goods sold. Though they do not manufacture their products they have to purchase them from the manufacturer which is the cost of goods sold.
One product business that often thinks it has zero cost of goods sold is the software business where a company delivers their product to their customer by way of a download from the Internet. Though their cost of goods sold might be very low there still are costs associated with fulfilling that order to the customer. That would include the cost of the server that stores the software and downloads the software, as well as any Internet expenses associated with the download.
Service businesses provide a wide variety of activities for their clients. In some cases the cost of goods sold are quite obvious. A great example would be an airline. The cost to deliver the trip to their customer includes fuel for the plane the employees that work for that trip which includes the ticket agent, the pilots, the flight attendants, and grounds crew. Additionally, if any food or beverage is delivered that would also be included in the cost of goods sold for an airline.
Another big service industry would be healthcare. These companies can include doctors in their independent practices or hospitals and clinics. Their cost of goods sold would be anything that is consumed to provide care to their patients. That would be drugs down to as simple as a tissue. One item that’s included in cost of goods sold is often overlooked is the time the professional provides the service. When a doctor is meeting with the patient that time would be included in cost of goods sold. The time a doctor is not directly working with the patient but is being paid, would be considered an expense. It can be a lot of work breaking down the labor associated with the service industry between cost of goods sold and expenses but it’s important to do so to manage a business properly.
The last business that many think has no cost of goods sold is the business of consulting. As with the healthcare industry where doctors need to track their hours spent directly with patients, a consultant should do the same for when they’re spending time directly consulting with a client. The time the consultant is not working directly for a client i.e. billable hours, would be considered an expense. That would include the time a consultant is marketing themselves to gain more clients. In addition to just the labor they spend with the client, items like transportation costs to the client such as gas, oil, maintenance, and other expenses related to a vehicle would be all included in the cost of goods sold.