Date: July 26, 2025
Time: 9:00AM-10:00AM MST
Location: Online Webinar
Presenter: Steven D Hovland, CPA, Certified Forensic Accountant
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Delegate CFO: Hello, everyone, and welcome to our webinar today. Today we’re going to go over cost of goods sold and the various items within cost of goods sold.
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Delegate CFO: My name is Steve Hubland. I’m a Cpa. And a certified forensic accountant, as well as the founder of Delegate Cfo.
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Delegate CFO: Thank you for joining us before we get going. We need to take care of some housekeeping items.
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Delegate CFO: The webinar will be about 40 to 60 min long, depending on questions and how many questions we get. This webinar will be recorded, and after the webinar is over we’ll be sending out a recording as well as the slides. If you’re watching this on replay. And you want the slides. Please email us and we will get those slides to you as quickly as possible.
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Delegate CFO: Also, please use the Q&A function within zoom to ask any questions.
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Delegate CFO: One caveat. When we’ve done this presentation before, we sometimes get questions where we have to do more than just a verbal response to the question. Many times we have to do a formula or kind of walk through a formula with somebody.
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Delegate CFO: If those questions arise, we may not answer those during the webinar just because they tend to take up so much time. So if you do ask that particular question. Don’t fret, we’ll we’ll get with you offline and kind of walk you through that. I just want to let everybody know that some questions will have to be answered offline as opposed to going through and answering them verbally, just because they they require a little bit more than just kind of a
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Delegate CFO: a verbal response on that. So with that, let’s go ahead and jump into our webinar again. We’re going through understanding the cost of goods, sold materials, labor overhead and break even. And even though it’s a big title, all those items really intertwine with one another, and especially they intertwine and have a significant impact on that last item on break. Even
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Delegate CFO: so, today’s agenda, obviously, we’re going to do an overview of cost goods sold.
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Delegate CFO: We’re going to go through materials. We’re going to go through safety stock and order, point direct labor overhead, and then, of course, getting down to the break. Even now it’s important to note that cost of goods sold on a very simplistic level is really just going to be your material, your direct labor, and your overhead, those 3 items combined together for the most part make up your cost of goods sold, and as we’ve kind of discussed before in previous webinars.
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Delegate CFO: the formula may be simplistic, but what goes into it can change and have a significant impact on your financial statements. So let’s go ahead and jump into the respective session.
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Delegate CFO: What is cost of goods sold well in a nutshell. Cost of goods sold is the direct cost attributed to producing goods sold and or product, or, I should say, services
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Delegate CFO: performed for your customers.
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Delegate CFO: It’s really any cost. The best way to think about it is it’s any cost that goes into selling that product. So if you sell a widget everything that goes into getting that widget from raw materials to ready to go on the shelf and hand to a customer to be sold.
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Delegate CFO: Every single one of those costs that go into getting to that point. Whether it’s direct or indirect
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Delegate CFO: is really what should be considered cost goods sold now from a financial standpoint.
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Delegate CFO: Cost of goods sold is almost always going to be a separate line item on your income statement. So on your income statement, you’re gonna have
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Delegate CFO: top line is going to be revenue. Next line is going to be cost goods sold.
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Delegate CFO: Then you have your gross margin, and then down below. That will be all your operating expenses, which are your sales marketing admin? So on and so forth.
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Delegate CFO: It’s important to note that the Koschka sold
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Delegate CFO: it significantly impacts your gross margin and your profitability.
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Delegate CFO: The reason being is, if you recall last week, in our gross margin, webinar, where we talked about the formula for gross margin is revenue minus cost of goods sold equals, gross margin.
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Delegate CFO: Your cost of goods sold will obviously impact that gross margin, because
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Delegate CFO: the higher that your cost of goods sold is the lower your gross margin, the lower your cost of goods sold the lower your margin.
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Delegate CFO: It’s also important to note that.
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Delegate CFO: understanding what is in your cost of goods sold
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Delegate CFO: can actually significantly impact your profitability.
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Delegate CFO: And the reason being is, you know, obviously, what we’ve seen here is, you know cost of goods sold? Is it part of gross margin?
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Delegate CFO: But if you don’t have an accurate or a firm understanding of what’s in your cost of goods sold.
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Delegate CFO: It’s very difficult to one have a proper sales price for that particular product
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Delegate CFO: in which, then, that obviously trickles down to net income, and it’s difficult to become more profitable, or even be profitable if you don’t have a firm understanding on what is actually in your cost of goods sold.
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Delegate CFO: So again, why is it important? It’s essential for pricing and profit analysis
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Delegate CFO: most of the time when you’re trying to determine what you should sell your product for, you’re going to use. How much does it cost 1st and then from there I’m going to determine what my sales price should be. And in this particular situation, the
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Delegate CFO: if you don’t understand what your cost of goods sold is, you’re going to probably incorrectly price your product, which then, of course, leads it down to incorrect profit analysis.
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Delegate CFO: kind of a real world example. We had a client so years ago who came on with us, and they had been in business for quite a while.
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Delegate CFO: and
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Delegate CFO: in their cost of goods sold. So they did a gross margin on all the products, you know. So they had revenue minus cost of goods sold. Here’s their gross margin.
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Delegate CFO: and that was kind of the driving point for their sales price for their different products.
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Delegate CFO: And we realized when we started looking at their analysis
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Delegate CFO: that in cost of goods sold they only had materials. They didn’t have any labor, and they definitely didn’t have any overhead.
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Delegate CFO: And so when you looked on on the face of just, you know, set, you know, sales price minus materials.
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Delegate CFO: Yes, they had a positive, gross margin, but they were confused as to why they weren’t really, you know, pulling in a decent amount of that income every year. Well, it turned out that when we went through and added in direct labor, and overhead into their cost of goods sold, which it should have been
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Delegate CFO: some of those products they were actually selling at a loss, I mean, their margin was actually negative on that. And so that’s why it’s essential to understand what is in your gross, what is in your cost of goods sold. So you make sure you’re selling it properly, and then, of course, that ultimately goes down to your profitability, because if
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Delegate CFO: you’re not selling at a proper price. You’re not selling it high enough. You’re ultimately taking that money out of your bottom line on that product. And so that’s key to that. And again, if you understand what is in your cost of goods, sold.
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Delegate CFO: it then helps you truly understand what you need to sell that product for, and what and or service, you know, even though we’re talking about cost of goods sold. And we’ll talk about specific physical products.
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Delegate CFO: This also trickles into service industries as well. You know it’s just in the service industry. Your mean cost of goods sold is going to be the salaries of your professionals or the individuals that are helping provide that service.
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Delegate CFO: So material cost definition. Obviously raw materials or material cost is going to be raw materials and components to in the finished product
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Delegate CFO: examples is, of course, you know, wood for furniture, flour for bakery chips for electronics.
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Delegate CFO: It’s important to note in here
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Delegate CFO: that on your material costs, if you see in that definition where we talk about raw materials and components.
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Delegate CFO: obviously, raw materials is kind of a no brainer on that, you know, if you’re building a let’s say you’re building an amusement park, right? And you have to bring in all sorts of steel and aluminum
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Delegate CFO: as raw material, and then form and weld and put it together onto the respective ride. That’s kind of a no-brainer but your components.
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Delegate CFO: So if you have to get a hydraulic motor and put it on there. But you don’t actually build the motor. You buy the motor from somewhere else. That’s still a component. That’s still a material cost of in this case, the amusement park, right? And so it’s important that when you’re looking at your material costs, you’re also bringing in all the other items that you have to put on that respective product. It’s still a physical material on that. It’s not just raw material. It’s everything that actually goes into that.
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Delegate CFO: And then the other aspect on material cost is
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Delegate CFO: especially obviously, if you’re you’re making physical products, you need to track waste obviously, spoilage and price changes. Waste is one of the more difficult items to
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Delegate CFO: accurately track, and an easy example of that is, say, you buy 8 foot by 4 foot piece of steel, and you have to cut out specific parts for that piece of steel
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Delegate CFO: most of the time. When you get done you cut out all the parts. There’s going to be a leftover parts of that steel, you know, just the outside of the template that got cut out
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Delegate CFO: that technically, is waste, you know, because you can’t reuse it. You can’t cut any more pieces out of it. And so that’s part of the waste. And so that’s part of the items that you need to track and build into your respective calculations. Now.
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Delegate CFO: the reason why I say that that’s 1 of the more difficult ones is
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Delegate CFO: true. Waste tracking will dovetail into a true cost accountant role. And so just so, you know, in the accounting world cost accountants are actually one kind of branch in the accounting world. You know, you’ve got tax accountant auditor
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Delegate CFO: cost count is usually another branch, because there’s a lot of formulas and understanding of how things go back and forth, so not all accounts can do cost counting is where ultimately what I’m saying on that
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Delegate CFO: spoilage again similar to waste. But spoilage is usually going to be for the most part on durable goods, you know. So again, in that example you see up above where we talk about flour for bakery, you know. If you’re grinding your own flour, you know you have the wheat berries, you’re grinding them.
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Delegate CFO: Usually it’s been said that you can only keep that for about 5 days, and then after that the grinds in that particular flower goes away, or is not really viable anymore. So that would be spoilage so similar with any product as well. So if it gets hit with UV light and it can’t be used again
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Delegate CFO: more or less, it’s been spoiled and or obsolescence.
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Delegate CFO: and then the other thing is price changes.
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Delegate CFO: and the key part on that is.
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Delegate CFO: if you’re buying from suppliers, you know, supplier A is supplier B, and A is where you normally get whatever the particular raw material product from. But they’re out of it. And you need to fill this order. So you get it from B, and let’s say their price is a little bit higher. You need to be able to account for that price change, you know. Is it a temporary price change? Is it going forward? Going to be the same? So you need to make sure you’re accounting for that.
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Delegate CFO: and we’ve got a question. Here
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Delegate CFO: are packaging and shipping materials included in material costs.
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Delegate CFO: Well, that depends on
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Delegate CFO: where we’re what we’re talking about here. And and that’s the the unique thing about packaging and shipping is
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Delegate CFO: general rule of thumb is
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Delegate CFO: if it’s to bring the material in and or get the material ready for the final sell product.
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Delegate CFO: then it would be considered a cost of goods sold if it’s to ship it out. In other words, put it into Amazon box and ship it out. That’s a selling expense. That’s not part of your cost of goods sold. And so you need to kind of track as to where in the process those costs are incurring with that product. So, in other words, you have a widget, but you’ve got to put it into, you know, a fancy little box that has all the advertising on it.
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Delegate CFO: but it has to be in that box before you could physically hand it to the customer. Then. Yes, that’s part of the cost. That is part of your material costs.
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Delegate CFO: Next part safety, stock and order point.
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Delegate CFO: Now, these are important, and you may be wondering why we’re talking about this when we’re talking about cost of goods sold. These actually come into play.
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Delegate CFO: both on the cost of goods sold and on the respective Breakeven. So safety stock really is just
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Delegate CFO: extra inventory kept to prevent stock outs. So in other words, you always have that safety amount sitting there while you’ve got to, you know you wait for your next order of raw materials. Come in. You still have inventory sitting there, and you have that wiggle room to be able to service the customer, and not, you know, all of a sudden run out of raw materials or run out of materials to make the product. And you have a customer that has a sales order, you know, and you run into that danger of them going to another particular
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Delegate CFO: competitor of your organization. So that’s the the key part on safety stock. Now order point, you know. Safety stock ties back into that. You know, the inventory order point is the inventory level that triggers new orders.
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Delegate CFO: This ensures that materials are available for production
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Delegate CFO: balances, cost of holding stock with risk of running out. And so the formula, there is obviously order, point equals, average daily usage. Times lead time plus safety stock. So
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Delegate CFO: what that formula means is your average daily usage. The best way to think about is happening. What’s your average daily sales, you know, sell 50 units every day type, situation.
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Delegate CFO: and then your lead time is the best way to consider lead. Time is
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Delegate CFO: when you go to order from your supplier of the raw materials. You know the second you, you know, send that purchase order, you know, if you hit, enter or we do a phone call.
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Delegate CFO: that’s the day that it starts.
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Delegate CFO: and then the day that it comes and eventually hits your dock. That’s your end day. So your lead time is pretty much the time between, you know, picking up the phone call and the product winding up on your dock.
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Delegate CFO: And so that’s what that particular item means. And then you add in your safety stock. So all these together will tell you, hey, this is when I need to make sure I get my inventory ordered, and the key thing in here is you have to have a budget together.
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Delegate CFO: Now, if you’re a mature company, and you’ve been around for 2030 years. You probably know how your cycles go, or if you’re a cyclical company, and you know how often or what you sell in particular October or November type situation, so you could probably get by without having a firm budget in there, you know, to be able to develop your order point.
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Delegate CFO: But if you you’re not a mature company, you need to have you have to have
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Delegate CFO: a budget in place as to how many units you plan on selling, because you’ve got to have this in place for that.
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Delegate CFO: Another thing to keep in mind when you’re looking at this particular formula, and a particular lead time
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Delegate CFO: is, a lot of people will order outside the Us. For the products, whether they go to Switzerland because of the you know. Particular aspects on, you know.
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Delegate CFO: consumable products from Switzerland or China. For whatever various materials
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Delegate CFO: there is a lead time there that is going to add in or there’s additional days that get added into that. So you have to be cognizant of that in your formula is, if your main supplier, let’s say, is in China.
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Delegate CFO: and you’re doing orders from them.
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Delegate CFO: You know. It could be upwards of 100 days from ordering from them for them to. When that product gets on the boat ships across the sea, gets the respective dock or gets a respective port, then it gets to your warehouse. It could be upwards of 100 days. So you need to make sure that’s built in. The other thing you need to keep in mind is especially if you’re ordering outside the Us. Is, what are the national holidays in those particular countries.
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Delegate CFO: for instance, for those of you who order your products out of China.
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Delegate CFO: you’re fully aware of Chinese New Year, and just for those of you who aren’t aware. During Chinese New Year almost the entire country shuts down. So from approximately mid early January to early February, and I’m just being general here.
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Delegate CFO: You don’t get any orders done, and so, if you’ve done your calculation, you have your standard calculation, and you need them to get you. The order has to be in by January 31.st
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Delegate CFO: Well, the odds are is that might not happen because of that. And so you need to be able to plan not only just your normal lead time.
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Delegate CFO: but what other aspects in those other countries? If you’re going outside the Us impacts how
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Delegate CFO: much or how much additional lead time you’re gonna need. So you got to keep that in mind on that. So we have a question here.
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Delegate CFO: How do I determine the right amount of safety stock and set an appropriate order number
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Delegate CFO: well on safety stock.
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Delegate CFO: And again, this kind of safety stock is kind of like the 1st formula that you have to do. And you think back to your algebra class safety stock really is taking your maximum daily usage of the best case scenario of how many products you’re selling per day
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Delegate CFO: times the maximum lead time. So that is kind of the most sales and the longest lead time. Multiply those 2 numbers together.
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Delegate CFO: then subtract out your average daily usage, minus your average or times your average lead time. So you take those 2 formulas, multiply them each other, and they subtract, and that will pretty much get you your safety stock. Now, again, you may want to round, because it’s never going to be exact. But that kind of gives you an idea as to how to do the safety stock again. It takes kind of
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Delegate CFO: best case scenario on sales. We’re rocking and rolling sales, but then we’ve got worst case scenario, and it takes forever for the other product to come in, so that kind of gives you that wiggle room on your safety stock. And then the other question is, what framework, formulas, or rules of thumb should I use for small businesses?
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Delegate CFO: You really want to do the same thing? You need to have one a budget in place because you can’t do an order point going forward. If you don’t know
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Delegate CFO: really what you need, because on that order point it’s using average to usage. But if you’re a company that you sell.
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Delegate CFO: you know, 30, 40% of your total revenue comes in the last quarter of the year. Obviously, you’re gonna need a heck of a lot more inventory in before then, and if you have, say a hundred day lead time, you probably need to have that inventory ordered no later than say May or June, just to make sure it gets in in time to be able to order through. So
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Delegate CFO: you want to use the same formulas regardless of your business size, but you also need to make sure you account for. Are you cyclical? Are you not linear? You know what are the different aspects within your business.
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Delegate CFO: So next item in cost of goods sold is direct labor
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Delegate CFO: that is really wages and benefits of the employees directly involved in production.
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Delegate CFO: And again, this includes
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Delegate CFO: assemblers, machine operators, bakers, etc. This excludes people in administrative sales, indirect roles. This is just the people that are physically
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Delegate CFO: an easy way to think about is physically touching the product or touching the material to get to the product. You know, they are directly involved in that
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Delegate CFO: one key that some companies forget is if you look at that 1st line item.
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Delegate CFO: where we talk about wages and benefits
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Delegate CFO: is the benefit part that sometimes catches people off guard.
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Delegate CFO: So if Joe makes, you know, 20 bucks an hour, and he’s working on the line a lot of times you’ll see companies take $20 an hour
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Delegate CFO: times, however many hours it took to build it.
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Delegate CFO: and then they consider that direct waiver.
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Delegate CFO: Well, even though you’re paying Joe $20, you still have to pay fica insurance, etc, etc. Those are all the benefits, and a lot of times what you’ll hear in the Cfo world is we tend to call that burden.
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Delegate CFO: and so you need to be able to have not only the wage, but the burden built in, and a very general rule of thumb is 21 to 23% kind of gets you to that burden rate. And so, even though Joe may be making $20 an hour
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Delegate CFO: after you factor in the burden of, let’s just say for simplicity. Let’s say it’s 20%.
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Delegate CFO: Technically, it’s $24 an hour of direct labor going into that product. So that’s that’s kind of the key in the direct labor area is
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Delegate CFO: not only the wage but the benefits on that, but usually we consider that to be called burden.
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Delegate CFO: And we’ve got a question here. How do I separate direct labor from indirect labor or administrative salaries?
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Delegate CFO: So again, you need to make sure you have obviously a tracking mechanism. You know, if you have people that are working out in the
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Delegate CFO: manufacturing plant.
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Delegate CFO: that’s where their salaries are. That’s where they should be tracked. And then, if you have indirect labor which is usually going to be your
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Delegate CFO: administrations, you know your your plant supervisor manager.
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Delegate CFO: They’re involved with everything. But they’re not directly touching every you know, product, run or type situation. So you’ve got to have that there
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Delegate CFO: lot of times. What I’ve seen or what our company has seen, is in the respective payroll. You know whether you use Adp or any other 3rd party payroll. Usually they will break out
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Delegate CFO: departments for their respective employees. So like Department 30 could be all the employees that are physically in the plant, you know. Department 40. Maybe you know the administrator, the supervisors and plant managers, you know, and then 50 could be your Admin people. And so then you’re able to actually break it out. So if you have all your employees in Department 30, you immediately know this is all direct labor. They’re directly working on products.
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Delegate CFO: 40 is going to be an overhead cost. They’re working on the products, but not directly on each individual product. So usually, that’s how we’ve seen it is
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Delegate CFO: one you you set up a code within your payroll software to say, here, you know, Department 30 is all direct labor drop department 40 is indirect labor, etc, etc, so that that tends to make a little bit easier on that. If you don’t have a very sophisticated tracking mechanism, we’ll go through that here in just one second.
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Delegate CFO: So overhead. Now, this is the area again, you know, at the earlier slide
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Delegate CFO: where we talk, I we talked about that much particular company that they didn’t include overhead overhead tends to get
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Delegate CFO: missed a lot. It’s not uncommon for a lot of companies to not properly include overhead into their cost of goods sold.
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Delegate CFO: So what is overhead by definition is really indirect costs associated with the production.
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Delegate CFO: And again, common items, you know, factory rent utilities.
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Delegate CFO: indirect labor of supervisor maintenance. So it’s really all the costs
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Delegate CFO: that are necessary to make the product, but can’t be directly, you know, taken or associated with that, you know, product run of, you know, widget A or Widget B.
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Delegate CFO: Another way to think about it is in your physical plant.
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Delegate CFO: You’ve got the lights turned on. Well, if you weren’t making that particular product, lights wouldn’t be turned on, you wouldn’t be incurring that energy. You know, the machines are running and you’re moving the product down through the, you know, doing those various machining
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Delegate CFO: the electricity for that mission, those machines that’s technically part of building that product. However, you can’t say, Okay, here’s my electric bill for the month. It’s $10,000, and I know exactly $8,342 is related to the product runs. And it goes to each of these products that
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Delegate CFO: you don’t have that level of sophistication. Nor nor do do you really need it, that but that’s kind of what overhead really is is
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Delegate CFO: looking at all those costs that are really associated with producing the product.
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Delegate CFO: But you can’t directly say, this is exactly to that. And again, another item in there you look at maintenance.
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Delegate CFO: So a lot of times, especially if you have a larger plant, you probably have, you know, 1, 2, or 3 people in maintenance that literally, that’s their job is going around making sure the machines run, fixing down machines, etc.
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Delegate CFO: Well, they are part of keeping that product moving, so they are cost of the goods sold. But you can’t allocate their salaries to each individual project in there. So again, it’s important that you have overhead built, or understand what your overhead is, and get it built into your cost of goods. Sold.
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Delegate CFO: Question here. 2 questions. 1st question
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Delegate CFO: probably have to do that offline. But the second question.
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Delegate CFO: what is the best best method to allocate overhead fairly.
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Delegate CFO: Now
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Delegate CFO: there are various methods to allocate overhead, and it really is going to be dependent on how accurate you’re able to track numbers such as tack time on the machines
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Delegate CFO: ideally, or I should say ideally, most of the time people use direct labor as kind of the method to allocate their overhead. So, in other words.
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Delegate CFO: they’ll take, you know, if it took 20 h to build this particular product, then they’ll allocate, you know.
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Delegate CFO: 20 h of overhead rate to that product. Now, next question you’re going to ask is, how do I get my overhead rate?
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Delegate CFO: Usually the best way to get your overhead rate is, you look at last year, and you say, Okay, what are all my overhead costs from last year? And then what was my total direct labor hours? Divide those hours, and that is for the entire year. So let’s say, it’s, you know, for 2024
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Delegate CFO: we had, you know, X amount of total overhead costs, and this included the rent, utilities, everything. And then you let’s say you had a thousand direct labor hours, and so take the 1,000 h into that overhead cost, and then that gets you kind of your overhead rate.
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Delegate CFO: So then, going forward in 2025, you’ll use that rate and allocate it based off labor hours. If you’re using labor hours
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Delegate CFO: as your respective allocation. Now, you can use other aspects such as machine hours.
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Delegate CFO: But you have to have a tracking or tracking mechanisms in place to be able to do that. So a lot of times people just go to direct labor because it’s the one that they can track, but again back to overhead.
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Delegate CFO: So we’ve figured out what our overhead rate is. We’re now in the current year, and we’re using that rate times, direct labor hours.
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Delegate CFO: Usually what’s going to happen is as you start going through the year. So you’re in January, February March. You’re allocating those costs. Eventually, you’re going to get to a point where you’re over allocated overhead or under allocated. Because keep in mind, we’re setting a rate based off of something that happened in 2024. And so that’s why it’s important. You track what you’ve allocated to make sure you don’t get too far out of balance.
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Delegate CFO: And you know again. It’s not uncommon that you’re over allocated in one month, and then you’re under allocated the next month as long as they for the most part net out, and, you know, smooth out as you go through. You’re okay, but you want to track to make sure you don’t get too far out of whack, whether it’s over allocated or under allocated, because that will mess up your cost of goods sold
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Delegate CFO: in 2 years. And what I mean by that is, you know, if you’re over allocated, your cost of goods sold is going to be lower in the current year. Assuming your inventory sits there and then. That means you’re going to have a higher, gross margin, higher, gross profit. Everything looks great.
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Delegate CFO: And then the next year, when all those costs that got over allocated then are released into the income statement. Then all of a sudden, you have lower. And so that’s why you want to track that. And one of the things you want to
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Delegate CFO: do is with your overhead costs in your general ledger. You want to make sure all your overhead costs are in one section, you know whether it’s by account, or you’ve grouped them into a section so that you have every single overhead cost and under true theory of cost, accounting
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Delegate CFO: your overhead that got gets allocated will show up as a contract. So theoretically, if if everything worked properly, you know, all your overhead costs, your overhead allocated, everything, then goes to 0. That doesn’t happen. I don’t know specifically on, you know your large companies like General Motors, but my gut is.
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Delegate CFO: no company ever actually hits 0, but you want to be pretty darn close to it. And so that’s where that’s what I’m saying, as you’re over under allocated is looking at those numbers to say, am I getting too far out of whack and a lot of times it takes 3 or 4 months as you go through that.
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Delegate CFO: So next item, break even analysis.
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Delegate CFO: Now, all this kind of
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Delegate CFO: gets us back to. We want to make sure we’re at least not losing money on everything. And so you have to do a break. Even analysis. Now, a very simple formula. If you’re going to use
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Delegate CFO: well, first, st I should say break even really is.
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Delegate CFO: Total sales minus total cost equals 0. So, in other words, your net income for the year is 0. That would be a true break. Even you know all your sales covered all your costs. You don’t have anything. You didn’t come in negative, nor did you have extra. You truly broke even.
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Delegate CFO: And so that is really what break even means.
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Delegate CFO: You know, a very simplistic formula
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Delegate CFO: is break even units, equals fixed cost divided by price minus unit cost. Again, that seems very complicated. And once you have those numbers broken out, it’s not overtly complicated. But the problem with that formula, and we’re going to show you an alternative way that we use with our respective clients.
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Delegate CFO: The problem with that formula is, if you have a brand new product.
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Delegate CFO: it’s really hard to be able to do this. You know. Particular form, especially, you know, it’s branded product. You’re launching it.
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Delegate CFO: You don’t really know what your break even is because you don’t have any sales yet, and you don’t really know what fixed cost allocate to it. And so it gets very, very complicated on that. So an alternative method that we do for our
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Delegate CFO: customers or our clients is we do it. A calculation based off of a percent. So
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Delegate CFO: first, st what we do is we’ll calculate the operating expenses as a percent of sales. So remember our kind of basic formula for the income statement. You know, sales minus cost of goods sold equals gross margin. Then everything below that is operating expenses we’re going to assume we don’t have any odd other expenses, so everything is operating expense.
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Delegate CFO: So you want to calculate what that percent is of total sales.
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Delegate CFO: And when you do this calculation, you want to do more than one month. Don’t just do one month, because that will get you skewed all over the place. So make sure you at least have a quarter, preferably more data, so that you kind of more or less, you’re going to average it out and smooth it out.
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Delegate CFO: So now we know that we want to do that operating expense as a sales as a percent.
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Delegate CFO: What that tells us is
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Delegate CFO: that is the percent that we have to have in our gross margin percent to be able to break. Even so. In other words, the the reason why this is beneficial is
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Delegate CFO: that gives us an understanding of this is my break. Even percent on, you know, company as a total, as a whole and kind of the barometer you use on your individual products. So let’s go into a quick example on this.
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Delegate CFO: So let’s assume we have a million dollars in sales
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Delegate CFO: and our operating expenses. Again, we have sales minus cost of goods, sold equals, gross margin, and then we have operating expenses below that. So our operating expenses, 200,000. So based on this formula, our operating expenses as a percent of sales is 20%. So what that tells us
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Delegate CFO: is that for this particular company our gross margin percent has got to be 20% or higher for us to break even and or make money on the respective company.
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Delegate CFO: And the way to think about that is, let’s say our gross margin is 200,000. So if we just look at simplistic numbers. If our gross margin is 200,000 and we minus out our operating expenses of 200,000, we’re going to be at 0, which is break even. And again, if we look at gross margin, 200,000, that then, is 20% of the respective sales. And that’s our gross margin percent. So
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Delegate CFO: the reason why that’s hugely beneficial is if you have a bunch of different products, you know, and they all have different little processes on being produced, some similar, some not.
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Delegate CFO: You need to be able to do an analysis of your margin on your individual products and an analysis on the company as a whole.
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Delegate CFO: So if you have this percent that at least gives you kind of an understanding of, here’s kind of the floor on this particular, you know, if we have a new product, here’s the floor. We have to be at 20%. Well, here are our cost of goods sold. So that means our sales price has got to be X. Now.
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Delegate CFO: that isn’t just a standal in stone. Must. Everything must be in this case 20%. You can technically have products below that.
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Delegate CFO: But you have to have an understanding that. Okay, if we’re going to sell this particular Widget B, and it’s got a 15% margin.
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Delegate CFO: That just means
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Delegate CFO: we, as a company, have to sell a lot more than we normally would to ultimately break. Even so, if you think about kind of the formula. Again, our operating expenses divided by sales. Let’s assume the operating expenses stayed at 200,000. And you know our gross margins at 15%. Currently. Well, then, that means we have to go. We have to have a lot more sales. So then.
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Delegate CFO: more or less dilute the percent of operating expenses to sales. So a lot of convoluted stuff. But if you see it on paper, it starts to make sense. So if you do have a margin on a particular product that’s lower than your your break. Even percent.
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Delegate CFO: You have to have the understanding that either one you have to sell a lot more, IE. Make it up on volume.
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Delegate CFO: or you need to understand that you might not want to sell that particular product, or or I guess a 3rd option is that product’s going to combine with a high margin item. And the net of those 2 is still about 20%. So but again, this percentage helps, you understand, and the way you can make your margin percent lower is to have better cost of goods sold, or better
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Delegate CFO: calculation on cost of goods sold
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Delegate CFO: the other benefit of this formula. Let’s say
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Delegate CFO: you have some overhead costs that should be in cost of goods sold, but you don’t have it there. This formula technically will account for it. So let’s say you have $100,000 in overhead. That really should be in your cost of goods sold in the same, the same example. So our operating expenses are now 300,000 versus 200,000. So that means our break, even percent is 30%.
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Delegate CFO: So if we kind of walk through the other side, our margin, if our margin originally is 20%. But we just took out 100,000 out of cost goods sold. That means we just bumped up our gross margin percent. And hopefully, that gross margin percent is at 30% or higher. So, even though you may have costs in the wrong bucket, which is not uncommon
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Delegate CFO: if you’re doing this particular formula more or less accounts for it, it just means that, hey? Your operating expenses are going to be higher as a percent of total sales. So that just means your margin has to be higher. And so you kind of get back to the same spot. And so that that’s the other benefit of doing this particular calculation. It kind of gives you that wiggle room in case you do have items in the wrong particular bucket.
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Delegate CFO: If I got a question here, if my material or labor costs increase, how much more do I need to sell to break even
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Delegate CFO: I’ll follow up with you on offline. But just generally
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Delegate CFO: it’s if you’re increasing, your cost of goods sold, and you’re not increasing your sales.
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Delegate CFO: That just means proportionally. You’re going to have to increase it, you know, depending on the product what your particular break even is, etc, etc. So that’s something we’ll have to show you online. And one thing for the general audience you should consider
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Delegate CFO: is in excel. There’s a Slider bar function, and you can build a Slider bar function into your actual formulas. You’re just, you know, kind of simplistic excel formula where you start, you know, moving back and forth, saying, Okay, what happens if this product is below 20%? Okay? Well, then, how do I get to break even. And then you can make it do the calculations. Now.
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Delegate CFO: lot of Youtube videos on that. So I suggest, if you’re not excel savvy, you watch all those videos 1st and then do a test run. You know where you actually did that. You calculate the answer outside of it, make sure it works. But, in other words, you audit
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Delegate CFO: audit that for them, and if you get that, then then that makes your life a little bit easier. If you do run into the situation. Okay, my labor and material costs have gone up. How do I account for that? So? And that’s very simplistic way. Now, there’s a other sophisticated Erp software out there. That will do that calculation. This is just in general how to do it with just using. Excel.
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Delegate CFO: Now, the main takeaways.
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Delegate CFO: know all the elements in your cost of goods sold. Make sure you track and manage your material labor overhead, and inventory closely, and again
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Delegate CFO: looking at your safety stock and your order points.
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Delegate CFO: and then use your cost of goods sold to make informed pricing, and your break even planning. Now let’s jump into. We’ve got a little bit over, but we’re going to see if we can knock out at least a couple questions. Here
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Delegate CFO: are software subscriptions or office rent considered part of cost of goods sold or overhead.
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Delegate CFO: Where do digital and recurring costs fit in the calculation?
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Delegate CFO: So again, it depends on what the software is for.
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Delegate CFO: So if you have say, you’re using one of the the Erp software to do your calculation to do your your inventory to do your
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Delegate CFO: build the material, your bomb reports. You know all that process that would technically be an overhead cost, because it’s really associated with building that particular product. Now, if it’s a quickbooks subscription that that’s an admin cost. That’s not really part of building materials, you know. You can have any other costs really over there that doesn’t really impact
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Delegate CFO: how the product gets built. But if you got Eci or one of those Erp softwares out there that has the calculation on the bomb and everything that’s predominantly going to be used for doing the production. Now, the accountants will jump into the respective bomb software, but that’s because we’re doing cost accounting. And sometimes we’re auditing the formulas to make sure the proper materials are being released.
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Delegate CFO: But for the most part that would technically be part of it. And then the other part of that question office rent
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Delegate CFO: so many times.
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Delegate CFO: What we’ve seen is, you have rent of a facility.
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Delegate CFO: and the facility is physically broken up between, you know. Here’s the plant, big wall, here’s the Admin offices where your salespeople, your accountants, etc. set.
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Delegate CFO: Now the rent is usually for the entire building. And so, technically, part of that rent is going to be overhead, and part of that rent is going to be for the Admin side. And so you just need to make sure you have some sort of logical calculation whether you’re doing square feet, which is kind of the more common way, or usable space, etc, etc. There’s other aspects in it so
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Delegate CFO: rent technically would be part of overhead, which then obviously would be in cost of goods sold. Assuming the rent is for the entire building. Now, if it’s office rent, and it’s just for the admin part, and it’s not for the physical plant part, then that would just be admin that wouldn’t be part of your your overhead.
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Delegate CFO: And what are the most common mistakes businesses make when calculating cost of goods sold, and how can I avoid them?
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Delegate CFO: Well, the most common mistake is not understanding that overhead should be part of your your cost of goods sold.
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Delegate CFO: you know. It’s easy to be able to see. Here’s materials. Yes, the physical materials, you know. Here’s the the labor now, obviously a lot of times. The burden on that particular labor doesn’t get brought in. But it’s really the other overhead parts. Because if you’re building that particular product, you know you’re losing electricity from the machines you’re using. You know, you’re paying for the insurance all the items
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Delegate CFO: to cover that plant
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Delegate CFO: that really is part of the cost that you need to build into that. Now, if you’re not building into it, then you need to do that break even percent that we just discussed on operating expenses of sales. You need to do that calculation so that you can at least account for it and understand that you know that just means your your operating expenses of sales are going to be a higher percent.
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Delegate CFO: But most of the time the common mistake I see in calculating cost of goods sold is not bringing an overhead in there and then the other aspect to that is over allocating overhead or under allocating. So
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Delegate CFO: even though you’re calculating overhead into your respective cost of goods sold, you still need to make sure your allocation is
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Delegate CFO: proper. You know you’re not over allocating or under allocating, because keep in mind. If you over allocate. That means you’re more or less putting a credit into the income statement. You know, credit is a sales
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Delegate CFO: calculate or a part of the sale. All your sales are credits. And so if you’re over allocating, you’re putting a credit. So you’re making quote revenue onto your respective income statement. And so that’s why you want to keep an eye on that. Because you know, the overhead rate you set up for 2024
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Delegate CFO: may still be okay for 2025, but it may all of a sudden you have a significant increase in rent and insurance. Electricity rates have gone up, and so that overhead rate might not be proper anymore, or it could be conversed all of a sudden. You have
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Delegate CFO: rebates on electricity and all that. So make sure you’re keeping an eye on that. Usually what we’ve done is about once a quarter. We’ll look at the over under allocations. You can’t just do month to month unless it’s way out of whack, because, theoretically or hopefully, it just zeros itself or smooth itself out the following month. A lot of times sometimes that over under allocation happens because of accruals and timings of that. So
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Delegate CFO: so
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Delegate CFO: that is today’s Webinar. I want to thank you for taking the time to listen about cost of goods sold again. My name is Steve Hoffman.
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Delegate CFO: I’m the founder of Delegate Cfo, and you can reach me at steve@delegatecfo.com. And if you want, you can go to our website, delegatecfo.com to learn more about our respective company and the recording and materials of this particular webinar
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Delegate CFO: will be sent out shortly. And again, if you’re watching this on replay, and you would like copies of the slides, just let us know, and we’ll try to get that to you as quickly and timely as we possibly can. And again I want to thank everybody for
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Delegate CFO: attending this webinar. And again, if you have any questions outside of this webinar that are formula specific, please don’t hesitate to email us, and we’ll try to get back to you in a timely fashion again. Thank you, and have a great day.