Cost Volume Profit Model
Step Method Allocation
Direct Method Allocation
COGS for a Service Based Business
If you are running a business with inventory, it’s easy to understand the G in COGS (Cost of Goods Sold). But if your Goods are employee time, how do you note your goods in the P&Ls
? How do you list the time on your balance sheet
The answers to this questions depends upon what you are trying to do with your P&Ls and what you are trying to do with your balance sheet.
Here is a school of thought regarding P&Ls.
Place all your service oriented employees salaries in COGS. What this does in a sense is place a debited amount against the income that you have coming in so when you look at the Gross Profit, you can tell your profit just based on the services that you are performing for your customers. You can now use this as a guide for hiring new employees that directly influence income. Through your gross profit, you will be able to tell whether or not you have enough GP to pay for more resources just as you would to determine if you have enough to buy certain quantities of inventory.
The important thing to note is that you have to be acutely aware of what your Expense ratio is. What that means is that if you add employees and it affects your GP, you will need to leave enough GP to pay Expenses so your net number is positive.
All of this said, if your goal is to have a high GP so that it looks good on your P&Ls, don’t do this! Leave all your service salaries in Expenses. This is just a different way to do tracking of Cost of Resources on your P&Ls. This can all be done outside of accounting in some type of operational cost reporting.
With the Balance Sheet, the problem often becomes, “how do I value an employee time on my balance sheet as an asset.” The answer is, “you can’t”. The categories of assets as understood by GAAP are:
2. Short Term Investments
5. Prepaid Expenses
Inventory comes close to being able to placing resource time on the books. But once again, “you can’t”. Coming close does not count in accounting. Accurately adhering to GAAP is vital.
So that you can increase your company’s worth on the balance sheet, there are a couple ways that you can place the money that the resources will make on the Balance Sheet:
1. Long Term Contracted Revenue – Asset/Receivables from income invoices generated for the life of the contract.
The first one (Receivables) is an easily understood principle. The second (Good Will) is much more difficult.
All of the practices noted are ones that you should deeply consult with a seasoned and professional CPA and Valuator before you try and tackle on your own. This article is to generate ideas and not to be used as accounting advise.