“Many businesses manage their overhead expenses to within an inch of their life but do not understand their cost of sales.”
This is often true for a very simple reason. Overhead expenses are relatively easy to understand in the context of a reporting period. Cost of sales expenses are a much more difficult proposition. There are so many factors that need to be taken into account to get a true cost of sales position.
The cost of sales is often the largest cost category in a business so it needs to be understood so it can be managed. Not only should the gross profit margin of all major products or services be understood, so should changes to this margin be monitored on an ongoing basis. Gross profit margins change for many reasons including, changes to input unit costs, productivity levels, waste levels, processes, and product or service design.
To understand the cost of sales within each reporting period, businesses will need to address some difficult areas. These include:
Work in progress – valuation of WIP can be quite complex and will have a big impact on gross profit results. It is very important to capitalise the direct labour component where labour is a meaningful component.
Inventory levels – stock takes are costly and often done poorly. The process is then further complicated by “stock received not invoiced” or “stock invoiced not received” elements. For smaller SME businesses without good management software, this can be very difficult.
Direct labour costs – there are several factors that need to be addressed to get accurate costs in this area. These include separating these costs from the overhead remuneration costs, matching the cost to the reporting period (through wage accruals or 4, 4, 5 accounting periods) and capturing the full cost of labour which includes changes to employee entitlements.
Other direct costs – often there will be a range of direct costs that are being reported in the overheads instead of the cost of sales. These costs need to be included in the cost of sales accounts to enable the business to get a meaningful gross profit margin understanding.
Larger businesses will have the resource capacity (management software, experienced staff and a proactive culture) to undertake this work and get a clear understanding of their gross profit margins. Less well resourced businesses will usually struggle to do so. For those businesses, an experienced financial specialist should be considered to provide this capability and enable the business to manage this major cost category in their business.