Companies incur and record costs in running the day-to-day operations of the business. These costs are separated into two categories—Cost of Sales and Operating Expenses. Cost of sales may also be called cost of services and cost of goods sold. Operating expenses are also known and SG&A—sales, general and administrative expenses. Companies also have non-operating costs that do not belong in these two categories. If your company buys fixed assets or buys another company, those are investing costs. If you pay back a loan, the principle amount is a financing cost; only the interest is an operating cost. Paying dividends to shareholders is a financing cost. Our focus is the operating costs of the business.
What is the difference between cost of sales and operating expenses?
Cost of sales or cost of goods sold represent the costs involved in making and delivering your company’s product or service to a customer. For example, if you make and sell a physical product, the raw materials, labor (including benefits to factory workers), factory costs like utilities and equipment, factory management overhead, shipping costs, etc. are included in cost of goods. For a service company, the salaries of the service providers and any other cost associated directly with providing the service is a cost of sales.
Operating or SG&A expenses can be considered as the overhead to run the company. Think of these as the ongoing costs just to be in business. These are costs for marketing, sales, information technology, human resources, accounting, legal and administrative. These functions are very important, but the people in these departments perform a support function in the business. They are not directly involved in making your product or service. Their services are not what your customer is buying.
Why are cost of sales and operating expenses separated?
These costs are separated for management and analysis purposes. Your company makes money by selling its product or service. Separating these costs allows a company to understand what it is costing to produce and deliver its products or services. Knowing these costs helps determine what those products need to be sold for to make enough ‘gross profit’ on each sale to cover the company’s operating expenses and leave a sufficient ‘net profit.’
Separating the costs makes it easier to see where the problems are if net profit is too low. Managers can look at the data to answer 1) are we not selling enough; 2) are we not charging enough; 3) is it costing too much to make the product; or 4) is our overhead too high?
For owners of small to medium sized companies, the more your company grows, the further removed you are from day-to-day operations. Having your costs properly allocated is essential so that you can understand what is going on in the business. Especially if profit is too low, the cost separation will allow you to see where the problem is occurring.