Cost of Sales / Cost of Goods Sold VS your average expense.
So, you’re claiming all your expenses, brilliant. But do you know what a direct cost is and what an indirect cost is? If you were to be asked your Gross Profit over your Net Profit, would you know the difference?
It’s not often you will need to know the difference but for product-based business, the Gross Profit is what many see as the key. Because if your Gross Profit is in the money, then the indirect costs that can be trimmed in certain areas / instances are almost irrelevant.
This is where Cost of Sales (COS) & Cost of Goods Sold (COGS) as direct expenses come in.
These are expenses where they make up the product or service you are providing. For example, you make wooden furniture to sell to customers, the wood, screws, glue, anything that makes up the product, even the delivery to get those materials to you, is a Direct cost – COS / COGS. Whereas the tools you used to make it, the electricity, rent of a premises, etc. are NOT direct costs. Essential you might say, yes, but they do not directly impact what the product makes you in Gross Profit. For service-based businesses, any material or software that you directly use in providing the service also counts toward these Direct Costs.
Most accounting software allows you to create categories / codes or accounts that help you put your expenses into different areas. Most of these will allow you to create categories for Cost of Sales, Cost of Goods Sold or Direct expenses. Doing so and then recording these expenses into specific areas can really help you identify where and what you money is being spent on, and possibly, what is making you the most money, allowing you to concentrate more on advertising that part or even dedicating more time to providing those products or services.
Reporting based on these will also help you to see whether your sales income is providing you with enough cash to cover your expenses. Or, if you are starting up, help you to see what kind of budget you have for your other expenses you expect to come in. Limiting your expenses to just your Gross Profit amount is an ideal way of maintaining good cash flow as well as ensuring you are using your hard-earned money wisely.
Do I REALLY need to differentiate my expenses this way? No, you don’t.
It all depends on how well you want your report to look. How much information do you want it to give you or your accountant when they look at it? The more data you give it, the more information you can get out of it. If you can’t be bothered and you don’t think it will help then don’t worry, OR, get someone else to do it, i.e. Middleton Professional Accounts Services and their team of awesome bookkeepers 😉
Again, this isn’t essential, and it isn’t required. But it is best practice!
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Stay safe out there, goodnight!