Although the primary purpose of running a business is profit-making, running a business requires owners to incur expenses. There are different direct and indirect expenses of a company that make it possible to perform day-to-day operations.
Bookkeepers and accountants are responsible for recording all the major and minor expenses that a business entity incurs. Expenses are basically the costs of keeping a business going on. But, there is often a debate that goes on: what is the difference between cost goods sold and operating expenses.
Despite both are recorded as an expense and deducted from the net sales, there are some differences. These differences are essential to be identified for keeping track of which costs are related to business offerings(product or service) and which expenses are incurred for meeting day-to-day requirements.
This article will attempt to differentiate the Cost of goods sold from operating expenses for all types of businesses working in varying industries.
Expenses are defined as the period costs. Expenses must be recognized when the revenues have been generated against those expenses. In other words, the expense is the cost of making money for any business. Some examples of expenses can be the Cost of raw material for a manufacturing business, hiring a lawyer for a legal firm, or recruiting a salesperson for a merchandising store. All of these expenses are directly involved in profit-making for a business entity.
All the expenses are deducted from the net sales to calculate the net profit of a company for a specific period of time. However, they are sub-categorized as direct expenses, indirect expenses, general expenses, and even non-cash expenses. The purpose of sub-categorizing the expenses is to have a clear orientation of which expenses play a role in profit generation for a business entity.
The Cost of goods sold is a direct expense related to profit generation. Therefore, it is the first one to be deducted from the net sales. After deduction, the gross profit or gross margin is found. On the other hand, operating expenses are sub-ordinates of COGS as they are helping in profit generation, but the nature is indirect. Let’s elaborate on each type in detail.
Cost Of Goods Sold
In simplest terms, the Cost of goods sold includes producing, purchasing, or acquiring the inventory that is sold by a business entity, either manufacturing or merchandising.
Cost of goods sold is defined as,
It is the sum of all direct costs incurred for producing or acquiring the goods sold by a business entity. For a services business, the Cost of services includes all the expenses directly related to providing services to the customers.
Cost Of Goods Sold For Manufacturing Business
In a manufacturing business, the Cost of goods sold includes manufacturing inventory costs during the current period and closing inventory cost from the last financial period. So principally, the Cost of goods sold comprises direct material, labor, factory overhead, etc.
Following expenses are included in the costs of goods sold for a manufacturing business:
It includes the direct material or raw material that is the primary input in the manufacturing process and the indirect material that helps in crafting the final product.
The labor costs are included in the labor. It can be per hour costs, wages, or monthly labor costs.
Factory overhead is described as the services that have been directly involved in the manufacturing process. It can include electricity bill of manufacturing unit, gas, telephone, maintenance of machinery & equipment, etc.
Closing Inventory Cost From Last Financial Period
The closing inventory from the last financial period is added to the next year’s inventory available for sale. It also becomes part of the Cost of goods sold for a year.
Cost Of Goods Sold For Merchandising Business
The Cost of goods sold for a merchandising business will be rather simpler than that of a manufacturing business. It includes the closing inventory from the last financial period and the part of current purchases that have been sold during the current financial period.
The realized price of the purchases include the Cost of actual inventory, any direct costs(contract signing, interest on credit sales), and the costs of inward transportation(if material). For instance, if a business is importing a product, it will add transportation costs to goods sold.
Cost Of Goods Sold For Services Business
A pure services business does not have any physical inventory or products that are sold. They will rather account for the cost of services provided to the customer. For instance, the accounting firm, a legal firm, a business consultancy firm, or a real estate appraising firm will not have costs of goods sold.
Formula For Calculating COGS
The formula for calculating COGS for a manufacturing company will be as follow,
Cost of Goods Sold = Opening Inventory + Cost of Goods Manufactured In Current Year – Closing Inventory of Current Year.
On the other hand, the COGS of a merchandising firm will be as follow:
Cost of Goods Sold = Opening Inventory + Purchases – Closing Inventory
Example Of Cost Of Goods Sold
A statement for the Cost of goods sold will look like this:
|Company ABC. Inc Statement for Cost of Goods Sold For the year ending Dec 31st, 20xx|
|+ Beginning inventory||xxx|
|+ Freight in and Freight out||xxx|
|– Purchase returns||(xxx)|
|+ Direct labor||xxx|
|+ Factory overhead||xxx|
|= Cost of goods available for sale||xxx|
|– Ending inventory||(xxx)|
|= Cost of goods sold||xxx|
Operating expenses, more commonly known as OPEX, are the indirect expenses of a business that are incurred to keep a business operational and running. Principally, the operating expenses include all the costs other than the Cost of goods sold. We can define operating expenses as,
Operating expenses or OPEX includes all the normal expenses of the business other than the Cost of goods sold. All the expenses not directly tied to the acquisition of inventory of sale or manufacturing of the company’s product are treated as operational expenses. Operational costs are deducted from the gross margin to get an operating profit of a firm.
What Is Included In Operating Expenses?
The most common examples of operating expenses are as follow:
Rent includes the monthly, quarterly, or annual payment for the office space or manufacturing plant.
Utilities include all the electricity, gas, telephone, water, etc., bills that are incurred for keeping the front office working.
Sales & Marketing
All the costs of advertising, marketing, and selling the products are added to sales and marketing. Sales and marketing expenses are included in a separate line item as S&GA Expenses
General administration expenses include administrative expenses.
Payroll is an item that deals with all the employees’ salaries and wages other than direct labor.
Office supplies include paper, stationery, printing charges, etc.,
Many indirect expenses go under the misc expenses. Basically, all the immaterial expenses are added to make a misc expenses item in the operating expenses.
Depreciation is also an operating expense, but it is a non-cash expense. Depreciation is calculated on the plant, property, and equipment of the company. It does not include land depreciation as the land is never depreciated in value.
Other Operating Expenses
There can be several other operating expenses depending on the nature of the business. It can include insurance, equipment, legal charges, consultancy expenses, etc.
How To Calculate Operating Expenses?
Operating expenses calculation is very simple. It is the sum of all the expenses that are not related to the production of inventory. The most basic formula for operating expenses can be:
Operating Expenses = Rent + Utilities + Salaries & Wages + Selling, General & Administrative Expenses + Office Supplies + Bad debts + Misc Expenses
Difference Between Cost Of Goods Sold And Operating Expenses
From the above discussion, the following differences can be identified between the two types of expenses:
Nature Of The Expense
The main difference between the two expenses is their nature. The Cost of goods sold includes the expenses directly related to the production or acquisition of inventory for sale. Whereas the operating expenses include all the costs incurred for keeping a business running and do not directly relate to inventory production.
The Cost of goods sold is classified as the direct expense of a business. Direct expenses are those that are related to the production or purchase of the main product or offering of a business.
On the other hand, operating expenses are classified as indirect expenses. Indirect expenses are those that cannot be attributed to a single product or service. Instead, they are used for keeping the business is running as a whole.
The accounting treatment of both expenses differs in a way that a separate statement for costs of goods sold is prepared in the company’s accounts. Whereas the operating expenses are deducted from the gross profit in the income statement of a financial period.
In A Nutshell,
Both the Cost of goods sold and the operating expenses are incurred for generating the profit for a business entity. Both the items are recognized as the expense account in the bookkeeping. Therefore subtracted from the sales or revenues. We have tried to comprehend the main differences between the two types of expenses that are recorded on a business entity’s income statement.
Reviewed by Sinra