Understanding The Difference Between Cost Of Goods Sold And Operating Expenses

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For any business, understanding the difference between cost of goods sold, and operating expenses is very important. It demonstrates the efficiency of operating expenses in the generation of goods and gives insight into the profitability or losses of a business. 

We take a look at the differences and similarities between these two accounting terms and what they mean. 

Also read: Find Retained Earnings

Table Of Contents

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Explaining Cost Of Goods Sold

The cost of goods sold (COGS) refers to the business expenses incurred by a company when producing physical goods. These costs are directly related to the process of making a product from start to finish. 

They include things like raw materials, transportation of those materials, machinery and labor used in the production of goods and moving products to points of sale. However, these costs are only taken into account when a transaction takes place. 

This is an important metric when calculating the overall profitability of a business and is the absolute lowest that you can sell a product for in order to break even. 

The formula for calculating the cost of goods sold for physical products is to take the beginning inventory and add any purchases made and minus the ending inventory. This will give you the cost of goods sold. 

Any manufacturing labor or direct sales costs can be added but don’t necessarily apply to all businesses. For service providers where there are no physical products the term is cost of sales. 

Also read: What Are Assets, Liability, and Equity?

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Understanding Operating Expenses

Operating expenses (OPEX) are understood as the cost of keeping a business running and are not directly linked to the cost of production of goods or services. 

There are many factors that need to be considered for operating expenses including rent of business premises, utilities, insurance and payroll among other things. These are all ongoing costs to the company and are not directly tied to production costs. 

It is essential to understand the operating expenses of a business in order to analyze its operating performance. For a business that has high operating expenses as a percentage of sales this can illustrate inefficiencies in the production process. 

Operating expenses are sometimes confused with capital expenditure, but there is a difference between them, and they are treated differently in a company’s accounts. 

Capital expenditure relates to purchased assets which have a multiyear life and are used in the normal operations of the business. This could be machinery or vehicles. The maintenance and repair of these assets however are treated as an operating expense. 

Budgeting for operating expenses is vital for any business in order for it to remain competitive. 

Also read: How To Prepare Your Accounts For New Hires

Costs Vs Expenses

While the terms cost and expense are often used interchangeably there are subtle differences between them. For a company, an expense is a cost of doing business while a cost is not always necessarily an expense. 

For accounting purposes, a cost is something that you have to expend resources on in order to acquire, transport or set up. But until that item has been used up or consumed it is considered an asset

In this sense, cost is most closely related to expenditure rather than expense. The reason why costs are frequently equated with expenses is that in a lot of cases the expenditure is consumed immediately which does render it an expense. 

Examples of this type of expenditure are monthly bills, salaries, and rent. All of these are related to a specific period of time and so these costs are treated as expenses. 

Even vehicles and machinery are eventually treated as an expense through depreciation. So when a product is made it remains an asset until it is sold, and then it is charged to COGS, and therefore becomes an expense. 

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Difference Between Operating Expenses & Cost Of Goods Sold 

The difference between COGS, and OPEX can be demonstrated by linking it to the company’s product. 

For example, a company manufacturing mobile phones will have the cost of raw materials, transportation of those materials, labor costs and then transporting the finished product to retail outlets. All of these costs relate directly to the production of the mobile phones. 

But the company also has to pay for the electricity and other utilities that it uses, as well as insurance, rent and other ongoing costs to the business

These expenses need to be paid regardless of what is happening with production and is not directly related to the manufacture of the mobile phones. In this sense, the costs are essential to the operation of the business but are indirect costs in relation to the product. 

So if a cost is directly related to the product it is a cost of goods sold. If it is related to the ongoing costs of maintaining the operation of the business but not directly linked to the product it is an operating cost

 

Similarities Between Operating Expenses & Cost Of Good Sold

Although there are important differences between the cost of goods sold and the operating expenses of a business there are also some similarities. 

Both COGS and OPEX are two categories of a company’s operating costs. This is because they both represent costs for the daily operation of the business and are related to the core function of the company. 

Without the direct cost of raw materials and direct labor there would be no product and without the premises, maintenance of machinery and insurance there would be no way of producing the goods.

However, payroll can be a source of ambiguity in this area. An assembly line worker’s payroll would be classified as directly tied to production while those of administrative staff would be operating expenses. 

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Final Thoughts

Understanding the difference between cost of goods sold, and operating expenses can seem confusing but when applied to the idea of a transaction can be readily understood. 

Each has an important role in the analysis of a company’s profitability and cost structure. 

We hope this guide to the cost of goods sold, and operating expenses has been helpful.

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Understanding The Difference Between Cost Of Goods Sold And Operating Expenses
James Wilson

After graduating from McCombs School of Business in Texas, James joined ThePayStubs as a CPA to make sure the numbers we provide our clients are correct. Read More

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