The Three Parts of Cost of Goods Sold


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eRank does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors.

Cost of goods sold, or COGS, are the direct items required to make the handmade items that you sell. The materials used to make your handmade items are generally what comes to mind. However, three components comprise the COGS amount. In addition to Direct materials, direct labor and direct overhead are the other two components of COGS.

Direct Material

Direct materials are all the individual items used to make your handmade items. It is important to track all materials used to make each handmade item that you sell. The material will, of course, vary depending on what you make.

If you sell vinyl decals, the direct materials are the vinyl and the transfer tape. Perhaps you include an applicator? that is also a direct material cost of the vinyl decal. If you sell candles, the direct materials are the wax, wick, and container for each candle as well as any decoration on the container.

Your finished item may include another item that is made first. If you sell wreaths, you may make a wood design for the center first and paint it. The direct materials of the wreath would include the wire frame, the material on the wreath, the ribbon, the wood, and the paint.

Direct Labor

With many handmade businesses, the owner of the business is the only labor. You may think that it is not important to track your time used to make the items that you sell. However, how will you know if you are making a fair wage for the work required?

Decide how much your want to make per hour and track the time that it takes to make your items. The time multiplied by the hourly amount will be your direct labor.

If you have someone that either makes the items or assists you in making the items, you will need to track their time in order to know how much to pay them. The pay may be on a per hour or per completed piece basis. Both are part of your direct labor costs. Labor that is not related directly to the creation of the handmade items, such as administration cost for accounting, is not included in direct labor.

Direct Overhead

The third component of COGS is Direct overhead. Direct overhead commonly discussed in relation to manufacturing and construction businesses. For a small handmade business, it may be difficult to identify and calculate the direct overhead amounts. It is important to understand what direct overhead costs are, in case your small business continues to grow and one day requires this calculation.

Direct overhead costs are those costs, other than materials and labor, that are directly related to the creation or production of an item.

For example, in a construction company, the cost to operate the heavy equipment required for the project including rent, fuel, and upkeep are the direct overhead costs. If a manufacturing company, it includes the cost to operate the machinery to make the items such as the utilities, maintenance, and other equipment costs. To find the direct overhead per item, you would calculate the total direct overhead costs for a certain period and divide that by the number of items made in that same time period.

Oftentimes, a company may not have a separate utility meter for the production portion of their building. If not, they will calculate the percentage of utilities used by that portion of the building as compared to the rest of the building and divide each utility bill by that percentage and apply it to direct overhead.

Again, most small businesses do not account for direct overhead in their COGS calculation. With many handmade businesses operating out of the home, this is especially true for many Etsy sellers. Understanding this component of COGS, though, is handy information and may come into play in the future for your business.

Check out eRank’s Profit Calculator tool to help determine if your products are generating the profit you want.

Summary

Keeping track of your cost of goods sold is a necessity to make sure that you are generating a profit. The cost of goods sold, however, is more than just the materials required to make each item. COGS includes direct materials, direct labor, and direct overhead.

Understanding what expenses to include with each of these components will ensure that you correctly calculate your gross profit on each item, allowing you to earn a good profit and grow your business.

Michelle Badger, Accountant (25 + years) and Etsy seller