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Watch Your COGS

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In: Columns > The Business End

By Nick Gould

Published on June 26, 2006

As a rule, small design practitioners are required to spend most of their time and energy just keeping their business going, so they have little time left to pore over their company’s financial statements (if they even maintain any). Moreover, most designers don’t have much experience—or interest—in financial matters, so these tasks tend to fall by the wayside when more engaging priorities arise.

My background is more “corporate” than most design-firm proprietors. Yet, when I took over the financial management of my current firm, it surprised me how challenging it was to develop a process for tracking financial results that is valuable from a planning point of view, yet still appropriate to the size and scope of a small business.

I was also surprised at how difficult the value and purpose of some financial concepts can be to grasp—at least when you are not a certified public accountant (CPA)! But now, after almost six years of on-the-job training, I can confidently say that if you are treating your design practice as a business—as opposed to a hobby or sideline—you should maintain a level of financial oversight that allows you to assess the growth and evolution of your business. You don’t need a degree in accounting to accomplish this, but you do need a basic understanding of several core concepts and the discipline to keep track of where the money is coming from and where it’s going.

This article describes one of the core financial principles I have found to be most useful in managing our design business and gauging success from quarter-to-quarter and year-to-year: “Cost of goods sold” or “COGS.” If you do nothing else to monitor the performance of your business, watching your COGS can help keep you on track.

COGS Explained

COGS is one of many obscure financial abbreviations you might find on a typical set of financial statements. COGS is a simple measure of the efficiency of your business, which, in turn, is a major contributor to the businesses’ potential profitability. So it’s important to keep an eye on it.

Technically speaking, COGS amounts to the characterization of an expense as having been necessary to the production of a product or delivery of a service. In other words, of all the expenses your business will incur in a given month, some of those expenses will go into COGS and some will stay in the category of normal operating expenses. One way to look at it is that COGS expenses are variable according to the amount of sales, whereas operating expenses tend to be fixed at more or less regular amounts. The more product you sell, the more cost you will incur to produce that product.

In a manufacturing context, COGS is the expense of materials, labor, and other direct costs that go into the production of the product. If you have a donut shop, the costs for flour, sugar, oil and other ingredients—on a per-donut basis—go into COGS. By contrast, the rent on the donut store or the monthly cost of your business insurance—expenses that don’t vary according to the level of sales—stay in operating expenses. If you sold twice as many donuts in May as you did in April, your COGS will increase for that month but your operating expenses will remain stable.

COGS is a useful tool because it provides an indication of how efficiently a business is producing the product it sells. This can be particularly illuminating on a comparative basis when you see that a similar level of sales has been achieved at a lower cost. This can mean that a company is learning how to streamline its operations or that the market is supporting a higher price for the same products. Either way, it’s a positive trend. Paying attention to COGS also helps to factor out unusual expenses that will depress profits in a given year. For example, if our donut shop spends $5,000 on a new illuminated sign for the front of the store, this one-time operating expense will impact the bottom line for that year, but the improvement in operating efficiency can still be recognized.

COGS for Designers

So, how does using COGS help someone running a two- or three-person design firm figure out how well they’re doing? It’s a bit tricky to think about COGS in the context of a business, like a design firm, that doesn’t produce a “product” and whose primary expense is the salary of the people who actually do the work.

Let’s invent a typical firm and take a look at the types of expenses that could be categorized as COGS:

Superstar Design is owned by two partners who do most of the design work themselves. When the need arises, the firm will also subcontract work to a freelance animator with whom they have maintained a close relationship over the years. Other than salaries and employee benefits (a health plan and a company-funded gym membership), the firm’s major expenses are limited to the rent for their one-room office and telecommunications costs (phones and Internet access). Superstar Design can’t afford to do much marketing, but they do run a small ad in a local business newspaper and make an annual trip to a popular industry conference. One of the partners is mainly responsible for sales and he typically spends about 25% of his time networking and developing new client opportunities.

In the scenario above, which of Superstar Design’s expenses should be categorized as “cost of goods sold”? Clearly, the office and technology costs are operating expenses. Similarly, marketing and sales-related expenses (such as the costs for networking with potential clients, advertising, and conference attendance) are not directly related to the delivery of the firm’s design projects. All of these costs would be (generally) the same whether the firm did a huge amount of business or none in a given year. On the other hand, fees paid to the freelance animator or other subcontractors on projects are tied directly to the completion of those projects so these should be entered as COGS.

What about salaries? To be completely accurate, Superstar’s employees will need to maintain timesheets that indicate the percentage of time spent by all employees on client work (as opposed to firm-support work such as marketing and administrative activities). Hours spent on client projects goes into COGS and everything else is an operating expense. To arrive at this calculation, you have to add salary and benefits for each employee and divide by the total number of hours they worked in that period. This gives you an hourly cost for each employee, which, when multiplied by the number of hours spent on client work, will tell you the portion of each employee’s salary and benefits that should go into COGS.

Superstar Design’s Income Statement

Now let’s take a look at Superstar Design’s financials for the last two years. As it happens, 2004 was a banner year for the company. The firm’s employees spent practically all their time servicing client projects, and the company was forced to make liberal use of costly freelance help to increase their capacity when needed. (The table below also introduces a new term: “Gross margin.” Gross margin is the difference between sales and COGS. This can be expressed as either a raw dollar figure or a percentage of revenue as I’ve done here.)

2004
Revenue
Project Fees350,000
Total Revenue350,000
Expenses
Partner 1 Salary (90%)90,000
Partner 2 Salary (75%)75,000
Freelance Expense100,000
Total COGS265,000
Gross Margin24%
Rent30,000
Utilities2,400
Marketing3,000
Telecom3,600
Partner 1 Salary (10%)10,000
Partner 2 Salary (25%)25,000
Total Operating Expense74,000
Total Expense:339,000
Pre-Tax Profit:11,000

Although the firm was technically profitable in 2004, the profit was slim and the gross margin for the year was a fairly narrow 24%. This means that the firm is operating close to the break-even point and could experience a cash shortfall if, for example, a client pays late or defaults completely. It’s not a bad year—the partners paid their salary and all other expenses with $11,000 to spare—that’s a successful year by any measure. But a more efficient structure might help drive even more cash to the bottom line and provide a bit more cash-flow “buffer.”

So let’s assume that, in 2005, Superstar elects to hire an in-house animator to replace the expensive freelancer they’ve been working with. This saves the firm money. Also, the partner who is responsible for sales decides to spend a greater percentage of his time on these activities. This means that the company must again hire a freelancer to replace the hours now being spent on marketing, but the marketing investment pays off in the form of an additional $50,000 in revenue for the year. With these changes, Superstar’s 2005 income statement looks like this:

2005
Revenue
Project Fees400,000
Total Revenue400,000
Expenses
Partner 1 Salary (90%)90,000
Partner 2 Salary (50%)50,000
Animator Salary (100%)75,000
Freelance Expense50,000
Total COGS265,000
Gross Margin34%
Rent30,000
Utilities2,400
Marketing5,000
Telecom3,600
Partner 1 Salary (10%)10,000
Partner 2 Salary (50%)50,000
Total Operating Expense101,000
Total Expense:366,000
Pre-Tax Profit:34,000

Superstar Design’s new strategy generated $50,000 in additional project fees that translated to a $34,000 profit for the year. But most importantly, in 2005 the firm serviced its clients at a 34% gross margin, a major increase over the previous year even though they had fewer employees in 2004. Basically, Superstar has learned that, given Partner 2’s relatively high salary, it is more efficient for him to spend his time generating additional work, which can then serviced by a less costly freelancer. By the same token, Superstar was bringing in enough work to justify the replacement of their freelance animator with a cheaper in-house resource. All of these effects are observed in the dramatic change in COGS (and the corresponding increase in gross margin). Superstar is now allocating its resources more productively and efficiently and this shows in the bottom line. This effort may pay off even more handsomely in ensuing years as sales increase and/or prices move higher, because the shop will then capture a higher percentage of that increased revenue, i.e. it will keep more of the money it makes.

Financial management of any small business is a challenge and every business owner needs to determine the right amount of time and effort to devote to these activities. This can be especially difficult for people without a financial background. But the ultimate health and potential of any business is written in the financials, and learning how to read these signs and understand how to affect financial performance from year to year is an important skill for any maturing business. It may take some time to get comfortable with managing your finances strategically, but when you begin to understand core concepts—like COGS—you are well on your way to a more streamlined, efficient and profitable enterprise.

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Nick Gould has witnessed the dotcom boom/bust/boomlet, and, to this day, finds it amazing that a small (but high-powered) design firm has provided more stability, security, and job satisfaction than any of his previous employers (including corporate law firms and Fortune 500 companies). Nick lives in his ancestral home of Brooklyn, New York with his wife and daughter.

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