Cost of goods sold versus operating expenses: Understanding the differences

Keeping track of daily operating expenses in your accounts is a fundamental part of running a business. Cost of goods sold and operating expenses are the two categories under which these costs are classified. Not only do they differ from one another on certain grounds, but they are also recorded as separate line items on the income statement. Thereby, making it crucial to know the key differences when completing your books.

What is cost of goods sold in accounting?

Cost of goods sold or COGS is basically an accounting term that refers to the direct costs incurred in producing or acquiring the goods or services that a company sells. Meaning, COGS is the aggregate of all that is included to get your goods or services to the market.

Examples of COGS include the cost of raw materials or supplies, direct labor and factory overhead expenses directly associated with the production process.

COGS represents the accumulated cost of producing or acquiring the products that your business sells, thereby helping you determine the amount that you should target when you are selling your product to break even before you bring in a profit. That is, to make a profit, you should ensure that your COGS is less than the dollar amount your business charges customers to buy your products.

How is COGS calculated?

The basic method of calculating COGS for a small business with an inventory to maintain is:

COGS = Beginning inventory + Purchased inventory – Ending inventory

This formula denotes the value of the inventory sold or made in a specified time period, and takes into consideration the ups and downs of a business over a period of time. Costs can fluctuate on many factors like demand and supply chain.

For more clarity, let’s consider a scenario in which your company starts with $10,000 in inventory, spends $2,500 on purchases during the time period (quarter), and ends with $500 in inventory. To get your COGS for the specified time period, enter your totals into the COGS formula.

COGS = $10,000 + $2,500 – $500

Your COGS for the quarter is $12,000.

What are operating expenses?

As the name suggests, operating expenses, also known as OPEX are business expenses incurred to maintain day-to-day business operations and support core activities.

Unlike COGS, operating expenses are not directly tied to the production of goods or services. However, they are a crucial component of a business’s basic operations and are unavoidable for most businesses. 

OPEX typically encompasses a broad range of expenditures, including but not limited to rent or lease, payroll (excluding direct labor), sales and marketing, equipment, office supplies and insurance. They don’t include interest, investment etc. paid out.

How is OPEX calculated?

OPEX, like COGS, can demonstrate your business’s profitability quotient. A rise in operating expenses translates into lower profits for your business.

Let’s consider an example, say you own a cafe for which you pay $1000 in rent, $4,500 in payroll expenses, $200 in sales and marketing, $250 in utilities, $50 in office supplies and $200 in insurance costs per month. Add together your expenses to get your overall operating costs for the month:

Operating expenses would be equal to $1000 + $4,500 + $200 + $250 + $50 + $200 = $6,200

Hence, your operating expenses for the month are $6,200.

What is the basic difference between COGS and OPEX?

OPEX are costs that are incurred during your normal business timings when the business is up and running. If any expense is not COGS, it’s likely to be operating expenses.

The direct cost of providing goods or services to clients is shown in the COGS line item. Purchases of direct materials and direct labor are two common examples of expenses that are accounted for in COGS.

Whereas, OPEX refers to expenses associated with supporting the business’s fundamental activities but is not directly related to the generation of revenue. An expense must be ongoing in order to qualify as an operating expense.

Spending on COGS is unquestionably crucial for meeting consumer demand and maintaining market competitiveness, but OPEX is as much important because a business can’t function without investing in items like rent, wages, sales and marketing, insurance or legal expenses for that matter.

Besides, OPEX doesn’t solely include overhead costs. In fact, it also covers expenses such as those related to research and development (R&D), market analysis and product research — that help foster growth and establish a competitive advantage.

Bottom line

If you are unsure about categorizing an expense as COGS, just ask yourself, “Would this expense have materialized even if no sales were made?” If “yes,” then this expense does not fall under the category of COGS. For instance, in the case of a warehouse full of inventory, COGS comprises the expenses involved in producing and shipping the goods to the warehouse. OPEX are the costs associated with maintaining the warehouse, which include rent and utility charges. Interestingly, according to research, inventory is the second-highest expense for a small business after labor, accounting for 17 to 25% of total spending.

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