Tax Advice

Should Service Businesses Use COGS (Cost of Goods Sold)?

When you think about cost of goods sold (COGS), you might think of a wholesaler or retailer who sells physical products, also known as “goods.”

Companies that sell products account for costs of goods sold on their profit and loss statement, and it’s an essential metric for understanding the total amount the business paid for expenses directly related to the sale of products.

But what if you have a service-based business? Should service businesses use cost of goods sold?

What Is Cost of Goods Sold?

Cost of goods sold typically refers to the direct costs involved in producing or acquiring products that the company sells. It can include:

• Direct materials
• Direct labor costs for factory employees
• Items purchased for resale
• Freight and shipping costs
• Parts used in production

It’s also a key component in calculating 2 essential business metrics: Gross profit and gross profit margin. You can calculate a company’s gross profit by subtracting COGS from revenue and calculate its gross profit margin by dividing gross profit by revenue.

Product-based companies that issue GAAP-based financial statements must account for inventories and costs of goods sold on their income statements.

Cost of Goods Sold for a Service-Based Business

Service-based businesses generally aren’t required to account for inventories and cost of goods sold. However, it might make sense in some cases.

Let’s consider 2 fictional companies and whether it would make sense to account for cost of goods sold.

Matlock & Associates is a law firm representing clients accused of criminal activity. They don’t sell any products, but preparing for a trial typically involves a lot of printer paper, legal pads, pens, sticky notes, and coffee.

These items are inexpensive, and it wouldn’t be worth their time to keep track of each piece of paper or pen. So the firm doesn’t account for inventory or cost of goods sold and instead deducts those items as materials and supplies in the year they pay for them.

On the other hand, Hot Spot HVAC Services is an HVAC company that installs and repairs air conditioners and furnaces. The company writes off many incidental materials and supplies, such as coils, ducts, and vents. However, they also keep an inventory of more expensive parts on hand so that technicians don’t have to make time-consuming trips to a local supply depot or leave customers hanging when a crucial part is out of stock.

So, Hot Spot HVAC Services does keep track of inventory and show COGS on its financial statements.

So, if it makes sense for your business, you can opt to track cost of goods sold. Most service-based businesses that do refer to it as “cost of sales” (COS) or “cost of revenues.”

Service Companies That Use Cost of Goods Sold

“Pure” service companies that don’t use inventory and parts to deliver their services may not track cost of sales or cost of revenue on the company’s income statement.

Examples of these types of business include:

• Law firms
• Accounting firms
• Consulting firms
• Real estate agents
• Financial advisors
• Tree service companies

These companies simply report direct labor costs and other costs of doing business as operating expenses on the income statement.

Other businesses might keep inventory on hand or purchase substantial parts and materials while performing services. Some common examples include:

• Software companies
• Auto mechanics
• Landscapers
• Pool services
• House painters
• Plumbers, electricians, and other tradespeople

These businesses may want to track all of the direct costs of performing services for customers and break out the cost of sales on their income statement.

How to Calculate Cost of Goods Sold

The formula for calculating COGS is:

Beginning Inventory + Purchases – Ending Inventory = Cost of Goods Sold

Beginning inventory is the ending inventory from the prior year’s financial statements. You add to that figure any additional stock purchased during the year, then subtract any inventory remaining at year-end.

Returning to our Hot Spot HVAC Services example, say the company had $10,000 of inventory in the warehouse as of December 31, 2021. In 2022, the company purchases an additional $11,000 of parts. On December 31, 2022, they take a physical inventory count and determine there is $8,000 of inventory on hand.

Hot Spot’s COGS for 2022 would be:

$10,000 + $11,000 – $8,000 = $13,000

Depending on your needs, your service-based business might also include:

• Direct labor for the employee wages for people who perform the service
• Sales commissions paid to sales representatives
• Incidental materials and supplies that go into completing the service
• Fuel costs for employees traveling to and from job sites

What Expenses Aren’t Included in Cost of Goods Sold for a Service Company?

Most service businesses incur some expenses regardless of whether they sell a product or service. These costs incurred as expenses shouldn’t be included in the total cost of sales for a services business. Some examples include:

• Administrative salaries
• Rent
• Phone service and utilities
• Insurance
• Interest expense
• Office supplies
• Advertising

Why Does Cost of Goods Sold Matter?

If you work in a service industry, understanding the COGS or cost of sales for your service company is important because it helps you determine whether you’re pricing your services appropriately. And when you use your COGS figure to calculate gross profit, you know how much excess revenue you have to cover your overhead, rent (office building or space), payroll costs (employee salaries), retirement plan contributions, and more.

For example, say Hot Spot HVAC Services typically charges a customer $1,300 to replace the compressor on an air conditioner. In evaluating its cost of sales, the company determines its costs to perform the work include:

• $600 for the compressor itself
• $200 for the technician’s wages and benefits
• $50 in incidental materials and supplies

So, each time the company does an air conditioner repair job, they incur $850 of hard costs, generate a gross profit of $450, and have a gross profit margin of 34%.

If that gross profit margin is too slim, the company may run into trouble covering its other costs, such as paying rent expense and other overhead costs, paying off debt, building up an emergency fund, and giving owners a return on their investment.

The company may need to consider increasing prices or look for ways to decrease costs.

So, Should Service-Based Businesses Use COGS?

Keeping track of costs of goods sold for a service business isn’t always necessary—especially if the business is a “pure” service business that doesn’t have any inventory or sell products. However, for companies that sell parts and supplies as part of their service, having an accurate record of costs of goods sold can help you track your profitability, file your taxes properly, and better manage your business’ financial health.

Looking for an accounting software solution that can handle all things COGS for you and your business? FreshBooks offers COGS as part of its suite of accounting features. In FreshBooks, it helps you track and categorize your expenses more accurately.

So, what does that mean for your business?

You’re in the middle of a project and keep racking up expenses on behalf of your client. Instead of worrying about being out of pocket, you can now simply track your spending on the go and categorize it as COGS.