Although the primary purpose of running a business is profit-making, running a business requires owners to incur expenses. Different direct and indirect expenses of a company 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 the costs of keeping a business going on.
But, there is often a debate: what is the difference between the cost of goods sold and operating expenses?
Some differences exist despite both being recorded as an expense and deducted from the net sales. These differences must be identified to track costs related to business offerings (product or service) and expenses 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 expenses include the Cost of raw materials 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 a company’s net profit for a specific period. However, they are sub-categorized as direct, indirect, general, and 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 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 help generate profit, 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 customer service.
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 costs 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 or raw material that is the primary input in the manufacturing process and the indirect material that helps craft 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 directly involved in the manufacturing process. It can include the electricity bill of the 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 sold during the current financial period.
The realized purchase price includes 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 the 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, an accounting firm, a legal firm, a business consultancy firm, or a real estate appraising firm will not have the 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 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, include 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., and bills incurred to keep 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. 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 company’s plant, property, and equipment. It does not include land depreciation, as the land is never depreciated.
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 unrelated to inventory production. 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.
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 cannot be attributed to a single product or service. Instead, they are used for keeping the business running as a whole.
The accounting treatment of both expenses differs so that a separate statement for costs of goods sold is prepared in the company’s accounts.
At the same time, 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 profit for a business entity. Both items are recognized as expense accounts in the bookkeeping.
Therefore subtracted from the sales or revenues. Both of these expenses are important to regulate your business cash flow positively.
To easily identify and separate these expenses, your business must be equipped with financial tools such as an all-around business expense tracking software that features corporate cards, bill payments, employee expense reimbursement, and many more to monitor your finances effectively.
We have tried to comprehend the main differences between the expenses recorded on a business entity’s income statement.
Reviewed by Sinra