Why you Need to Separate the Chaff from the Wheat...on your PnL
Today we are getting a little bit technical with accounting.
Every now and then I hear CEOs putting all the costs in the same bucket without understanding the benefits of doing a little bit of accounting homework on their financials. So I want to explain why COGS (Cost of Goods Sold) is one of the most important financial metrics for your business.
COGS are the costs directly linked to your business sales. These are the costs that you can’t run away from (ie. you need to buy flour to bake a loaf of bread). This means that the right allocation of these costs will give your gross margin.
Knowing that could be very powerful for any business owner, as the most efficient way to increase your profitability is by cutting costs in COGS. If you change the flour supplier for one that gives you a 50% lower price, you increase your bread sale profitability by 50%. As simple as that.
Now in the world of services and tech companies, the majority of direct costs will be staff. This is valid for businesses in which to increase sales, you need to hire more (more consultants, more engineers, etc.). The benefits of attributing direct costs are the same, but instead of looking for cheaper suppliers, you seek automation of human-provided services or eventually cheaper staff.
The second reason why COGS are so relevant is for tax incentives. For a few jurisdictions such as the US, businesses that sell physical goods can claim tax income deduction for their COGS.
How do we differentiate COGS from Operating Expenses, a.k.a. OPEX?
OPEX is your indirect expenses: marketing, office rent, administrative staff, etc. These are all the costs that go towards running the business itself, rather than creating and delivering the product. We usually get economies of scale with OPEX items. So instead of having to incur more costs to increase your sales, you can afford to maintain the same level of admin staff, or same office, for example.
Hopefully just getting this initial framework will incentivize you to get a closer look at your books. Trust me: you can’t improve what you can’t measure.
🎧 Podcast recommendations
▶️ Teka Teka: On social media, COMELEC can’t do anything about premature campaigning: My lovely friend Regina shows brilliantly how social media affects (negatively) so many other countries politics far from their headquarters in Palo Alto. She’s the former host for Bloomberg TV in the Philippines and now is co-hosting this great podcast.
▶️ Business Breakdowns: Solana, Faster and Cheaper: Best podcast I listened so far explaining the reason why we see so many comments around the superiority of Solana as the winner blockchain for DeFi. For those of you interested in my opinion: I’m still long in EHT… 😅
This is Open Books - a weekly newsletter carefully curated by me, Leticia Souza. Every week I’ll be compiling relevant topics around finance and financial strategy - from choosing your first accounting system to how to successfully close a fundraising round to your business.
In a world full of noise, I aim to bring clarity and direction to your finance processes so you can manage your business in peace. If you find the content useful, do your friends a favor, and please share this newsletter with them.
See you all next week 👋🏼
Leticia
Cute puppy!