This is a longer article, so I’ll post it in sections. Part 1 – Part 2 – Part 3 – Part 4
It’s conventional wisdom that companies die because they run out of money. One reason they do is that if you’ve never learned to look at why you spend money, you make all money decisions the same way: Urgency. In this series of posts, I’ll try to show you some other options.
Where does the money go?
Actually it only goes 4 places. Or more correctly said, a business spends money for only 4 reasons. One of the problems with traditional accounting methods is they only tell you what you spent money on but not why. This is a problem because you can make better decisions if you think about why. The good news is there are only four reasons. We’ll cover the first one here.
It all comes from the customer.
Where does the money come from? The only place is sales. From Customers. The only place. Investors and lenders may supply cash but that’s not “real money” it’s only a temporary fix, because you have to pay it back [hate it when that happens].
COGS
The first reason to spend money is to have something to sell. Accountants call this COGS (Cost Of Goods Sold) or Variable Costs because they vary with the number of units you sell. Double your sales and COGS will double. Sell zero and COGS will be zero. COGS includes the actual stuff you sell (like the burger and the bun) plus packaging & shipping costs (plate and napkin) garnishes (ketchup and mustard) and relevant labor.
The first way to think about managing COGS is percentage. Your COGS should be a certain percentage of your sales. The actual percentage varies with your product and your industry. Food costs at a restaurant are typically around 35% liquor costs are around 20%. [Now you know why the first thing the waiter says is “Can I take your drink order?”] I imagine COGS at Starbucks are much lower and those at a car dealership much higher. If you don’t know what’s standard in your situation you should find out and try and beat those numbers. You can improve your percentage by lowering costs or by raising prices. Try both and find the happy medium.
The internet stunned everyone back in the 1990’s because it looked like COGS would go to zero. Compared to a book or newspaper there is no cost of paper, printing, or distribution. One problem was there were no sales either. But the other problem was in some situations it makes sense to count the cost of sales as a COG. Commissions, for example, vary directly with sales and should be counted as such. Of course, if sales are zero then any COGS at all makes for a very high percentage.
Timing
The other trick in managing COGS is timing. Usually you need to pay for stuff before you can sell it, otherwise you have nothing to sell. If your customers pay on terms, it takes a while for you to get paid while you have to lay out more money to have something to sell your next customer. This is one reason distributors often give their customers terms – in effect acting like their bank. Where’s the interest on those loans? In the price. You get a discount if you pay COD or within 10 days.
Many companies use lines of credit to deal with the timing issues of COGS. If their sales are seasonal, they’ll need cash to buy more before they sell, and will have cash after the season to pay it back. A growing company needs cash as well because they have to stock the shelves to keep the growth on track.
Obviously if something sells more quickly, you’ll get your profit faster than if something sells more slowly. Timing of this sort is measured in inventory turns. Either how many days does it take to turn your inventory, or how many turns do you get in a year. Given a fixed percentage of COGS, more turns will lower the cost of cash you have to borrow to fund COGS and will toss off more money each month to be used for the other reasons you spend money. Again there are standards for your industry and product. Learn them and try to beat them
To think about COGs spending you have to consider the percentage (mark-up) you’ll be able to sell it for as well as the timing and turns.
Takeaways:
- Know what percentage of sales your COGS should be for each product (or relevant product line). Industry trade groups should be able to tell you what’s normal. Then adjust that for your specific situation. Lower is better – makes you more profitable and less vulnerable to competition.
- You can lower your percentage by lowering the cost of COGS or raising your prices. Try both.
- Timing is a factor. You’ll need cash to pay for inventory before you can sell it. This can vary by month if your sales are seasonal or be a constant need if your sales are growing.
- If the rest of your company is sound, getting cash for COGS because your seasonal, or your growing should be a no-brainer. If distributiors aren’t willing to give you terms and banks won’t give you a line of credit, maybe they know something you don’t about the health of your company. Clean that up first.
- Accounting terms: COGS are also called variable costs. The amount left from a sale after you deduct COGS is called Gross Profit. The % of sales that is your Gross Profit is called Gross Margin and the amount you charge above your COGS is called markup. So let’s say you pay $10 for an item that you sell for $15. Your Mark-up is $5 or 50%.[More than you need to know: a 100% markup used to be typical in retail – it’s called a keystone.] Your Gross Profit on each sale is $5 your Gross Margin is 33.3%. Your COGS is $10 or 66.6% of sales.
