Service Industry: What's The True Cost Of Goods?

Cost of Goods Sold (COGS) is a critical financial metric that can impact a company's profitability, inventory management, and production decisions. While the concept of COGS is applicable across industries, the components and calculation methods can vary. In manufacturing industries, COGS typically includes direct material costs, direct labour costs, and manufacturing overheads. On the other hand, in service industries, COGS may include labour costs and other direct costs related to service delivery, such as travel expenses. It is important to note that service companies typically do not have inventories or goods to sell, so they cannot claim a COGS deduction on their income statements. Instead, they have a cost of services, which includes all the direct costs involved in performing the service.

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Direct costs of producing goods or delivering services

The direct costs of producing goods or delivering services are typically referred to as the Cost of Goods Sold (COGS). COGS is an important metric on company financial statements as it directly impacts a company's profits. It is calculated as follows:

COGS = Beginning inventory + Purchases – Ending inventory

COGS includes all the direct costs involved in producing a product or delivering a service. These costs can include labour, materials, shipping, sales commission, and transportation. For example, if you own a delivery company, your COGS for the first month of operation might include the cost of gas for the delivery truck and the salary of the driver.

It is important to note that COGS differs from operating expenses (OPEX) in that OPEX includes expenditures that are not directly tied to the production of goods or services. OPEX refers to expenses that a business incurs whether or not a product or service is sold, such as employee salaries, rent, phone bills, and utilities.

While the traditional COGS formula is based on the inventory costing method, service businesses often do not have inventories. Therefore, service businesses may find it challenging to calculate COGS using the traditional formula. Instead, they may refer to this metric as the cost of sales, cost of revenue, or cost of service. For example, a plumbing company's COGS would include direct labour, tools, parts used, and transportation costs.

Indirect costs

While the cost of goods sold (COGS) includes all the costs directly involved in producing a product or delivering a service, there are also indirect costs that can be included in COGS. These are expenses that are not directly related to the performance of an activity and are not included in the cost of sales.

For service-based companies, COGS calculations can be challenging because they do not have inventory or goods to sell. However, they may still have some products to sell, such as airlines selling gifts and food, which are considered goods, and these companies have inventories of such goods.

Some examples of indirect costs for a service business include:

• Overhead expenses such as rent, utilities, phone bills, and other administrative costs.
• Salaries of employees not directly involved in revenue generation, such as receptionists or accountants.
• Sales commissions paid to secure a job or contract.

These indirect costs are not included in the cost of goods sold but are still important expenses for a service business to consider when managing their finances and calculating their overall profitability.

Operating expenses

OPEX typically includes selling, general, and administrative expenses (SG&A). Examples of OPEX include salaries of employees not directly involved in the production process, such as receptionists or accountants; rent; phone services; and utilities.

In the context of a service company, OPEX may refer to labour costs associated with delivering the service. For instance, a tree service company's OPEX could include the sales commission paid to a sales representative who secured a job for the company.

OPEX also encompasses overhead expenses, such as the cost of an office and administrative budget, legal and accounting services, distribution costs, and advertising.

It is important to differentiate between COGS and OPEX when preparing financial statements and income statements. While COGS is subtracted from revenue to determine gross profit, OPEX is presented separately. This distinction allows analysts, investors, and managers to understand a company's profitability and efficiency in managing its production process.

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Cost of labour

Labour costs are a significant component of total production costs in the service industry, ranging from 30% to 60% depending on the complexity and expertise required. These costs include salaries, wages, benefits, and taxes. They can be divided into direct and indirect costs. Direct costs refer to expenses directly related to the service provided, such as the cost of labour to deliver the service. Indirect costs, on the other hand, are not directly linked to the service but are necessary for the business to operate. Examples include salaries of receptionists or accountants.

It is important to note that labour costs are not limited to wages or salaries. They also encompass benefits, such as health insurance, retirement plans, and other perks that contribute to an employee's total compensation package. Additionally, employers must contribute to mandatory federal programs like Social Security, further increasing labour costs.

The type of business, industry, unit labour cost, location, and number of employees all influence labour expenses. For instance, labour costs in the restaurant industry tend to be lower due to tipping, whereas labour-intensive industries like construction or retail may have higher percentages.

Labour cost percentage, calculated as (Total Labour Cost / Total Sales) x 100, is a crucial metric for businesses. A range of 25% to 35% is generally considered optimal for profitability while maintaining a productive workforce. However, this may vary depending on the industry and business model. A lower percentage may indicate an efficient business model, but it could also suggest underpaying employees. Conversely, a high labour cost percentage might signify excessive spending or inefficiencies in labour utilisation.

To effectively manage labour costs, businesses can implement strategies such as careful hiring, using temporary labour during busy periods, and utilising labour forecasting tools. Benchmarking against similar industries and competitors can help identify areas for improvement and cost savings. Additionally, tracking labour costs relative to revenue enables businesses to evaluate the profitability of their services and make informed decisions to optimise their workforce and expenses.

Cost of inventory

While the cost of goods sold (COGS) is a term mostly associated with the manufacturing industry, service or skill-based industries use the term "cost of revenue" to express their costs. One of the key differences between the two is the calculation and maintenance of inventory. The cost of inventory plays a major role in the calculation of COGS, but there is no such thing when calculating the cost of revenue or services.

Inventory costs refer to all the costs associated with holding and managing inventory. These costs include expenses related to ordering, warehousing, protecting, and deterioration. Inventory costs start building from the moment an order is placed. They include the cost of purchasing the inventory, storing it in a warehouse, and moving it throughout your network.

There are three primary categories of inventory costs: ordering, carrying, and stockout costs. Ordering costs refer to the fees and expenses for keeping items stored before they are sold. These can include first-mile delivery, warehouse receiving, and other fees. Carrying costs can vary based on the type of product and the costs of storage, and may include taxes, insurance, labour wages, and warehouse rent. Stockout costs represent the loss of income and additional expenses resulting from inventory shortages.

Capital costs are another component of inventory costs. These are the costs that a company incurs when borrowing money to finance inventory. The cost of capital can differ depending on the source of financing. For example, a director or major shareholder may accept a 5% return on their investment, while an investment company may expect a 25% return. If the money is borrowed from a bank, the cost of capital will depend on the given interest rate.

Overall, inventory costs can have a significant impact on a business's finances. Holding too much stock can have disastrous financial consequences, as capital tied up in inventory cannot be used elsewhere. By adopting more effective inventory practices, businesses can attain significant reductions in inventory and improve their cash flow.

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