How well do you understand your material costs? How are you accounting for freight-in costs? How does that relate to your Cost of Goods Sold (COGS) line item on the income statement? How about your gross margin vs. net income? Have you benchmarked each of these as a percent of sales?
This is quite the flurry of questions for a business owner who knows their craft but does not know accounting & finance topics very well. We love cases like this, because the client can give us the information we need to put these things together, and in return the client can better understand what the numbers represent.
Material costs are generally the starting blocks of the COGS section. How do materials arrive at your facility? Do they need to move from a production facility to a retail space? Some companies take freight-in or shipping costs and dump them into a generic “shipping/freight” expense account.
Why is this important? As long as the costs are caught somewhere on the income statement, the bottom line is the same, right? Technically, that’s correct – there is no net change to the bottom line. However, from a business owner’s perspective, this is providing junk data that leads to poor decision making. Let’s dig into an example:
Let’s say you make and sell 100 items. Let’s assume material costs per item are $10 and shipping costs per item are $40, however unrealistic that may seem. Let’s also ignore labor & overhead costs for now (and tackle them in later blogs!). So, at 100 units you have total material costs of $1,000 and total shipping costs of $4,000. If you sell each item for $60 (60 x 100 = 6000), how does this look?
|No freight-in recognition||Freight-in recognition|
|Sales = $6,000||Sales = $6,000|
|Materials (COGS) = $1,000||Materials (COGS) = $5,000|
|Gross margin = $5,000 (83%)||Gross margin = $1,000 (17%)|
|Freight costs = $4,000||Freight costs = $0|
|Net income = $1,000 (17%)||Net income = $1,000 (17%)|
What if a customer wants to place a big order but at a discounted rate? You may look at the left non-recognition example and think “hey, we’re making 83% on the product, we can definitely sell it with volume discounts”. If you don’t look at the total picture, it’s easy to make poor decisions on strategically setting prices. You may lose money on orders that you thought would be big wins. For businesses with many product/service lines, you may lose track of which lines are winners and losers. Once you start mixing freight-in expenses and freight-out expenses (which is a selling cost), this data quickly becomes useless for analysis.
We have first-hand experience fixing these exact problems for our clients!
Want some help assessing your material costs? By leveraging technology (from a simple phone call to a Skype call or Join.me meeting) we can help you regardless of your location! We offer free consultations up to 60 minutes, and we’re available during non-traditional business hours. Contact us today!