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What Service Businesses Miss on Their Profit and Loss?

Imagine you have a very delicious pie and the pie represents your Sales, on the side you got two of your friends to eat first before you (COGS and OPEX). What if after they ate nothing is left to you, or just a little bit….how would you feel?

Now what if you three agreed on a set limit say:

  1. 50% for your friend 1 who cooked the pie using his special secret recipe (COGS)
  2. 25% for your friend 2 for helping friend 1 prepare the ingredients (OPEX)
  3. and 25% for you for going to the grocery and buying the ingredients. (Net Income)

Assuming you three contributed money equally. Will this be a fair arrangement?

After working with several service type businesses, I noticed that there is a common misconception whether service type businesses have Cost of Goods Sold. Add to that the fact that QuickBooks Online do not have a Cost of Service account but only Cost of Goods Sold in the Profit and Loss… What???

But why is it important to properly recognize your own Cost of Services? What use can it give you? Are you wondering which of your services give you the most money? Which of your services you do more efficiently than the others? And best of all which of your services you love doing the most and how profitable is that kind of service activity?

During my previous years in corporate office being an Inventory Accountant, I have learned that Cost of Goods Sold is just as plain as it is for the Retail Industry. Purchase cost of the products sold, shipping fee, storage costs, and any other costs directly tied to the product itself will form the Cost of Goods Sold. Salaries of the Sales Persons and Admin staff are always part of operating expenses.

Now what about service type businesses which do not sell tangible products to its clients? There are basically three rules you can follow by asking these three questions:

1.  “Does this expense occur ONLY when services are sold?”

2.  “Does this expense go up-and-down as the sales goes up-and-down too?”

3. Are these costs directly used in the services provided?

Now for service type businesses what are the most common costs that should form part of cost of services? Let’s take a computer repair shop for example, it is a service type business but it also sells computer spare parts and peripherals occasionally. Now does it have a cost of goods sold or cost of services account? The labor cost paid to its technicians who do the repair work and the items occasionally sold due to need for the repair of the computer should become part of Cost of Services.

Now let’s take a look at hotels. Hotels sell accommodation services and can sell foods, beverages, and snacks too. Hotels do have inventory, but those inventory supplies are integral part of the hotel accommodation services. So, they shall form part of Cost of Services!

Now what is the standard way of determining it? It is more of the management decision on how and what to recognize as cost of services. Here are some of the more obvious examples:

a.  Sales commissions

b.  Direct labor cost, wages, or contractor costs of employees, freelancers, or contractors who directly do their work in relation to providing your services to your clients

c.  Flat fees for professionals who do your projects

d.  Rental costs of equipment directly used in providing your services

e.  And should you be using a software for the sole purpose of providing your services to your clients – this is very applicable to digital marketers using specific set of online software to do their marketing thing.

Now let’s dive into why recording your Cost of Services properly is so much important!

Have you ever seen or even heard of a service you can sell without incurring a single penny to provide to your clients? Could a voice be sold without a cost directly tied up to it? Can you sell your knowledge or any skill you have without a cost to incur? Absolutely not! 

But why is it really important to understand your own cost of services? Here are some of the key benefits you can get:

1.  To determine proper Gross Profit

It is a requirement to record your cost of services before you can get your gross profit

2.  Understanding your Gross Profit helps you compare your company to the competition

3.  You can better measure how profitable your income generation activities are.

4.  Gross Profit will show you how efficient your revenue generation is

5.  You can focus on doing services that give you highest gross profit ratio

6.  Ideally Gross Profits should be at least half of your Total Sales

This is especially important to know since your gross profit will be the one to be used to pay your operating expenses before you arrive at your bottom-line

7.  Separating your Cost of Services from operating expenses will help you to scale up your business since cost of services will be the one to consider most when increasing your Sales

8. Proper Costs of Services will give you a better basis of pricing

9.  Finally, you can compare Gross Profit vs your Total Operating Expenses.

Gross Profit should always be larger than Total Expenses

An ideal ratio of Gross Profit vs Total Expenses should be at least 1.25: 1.00. This means you will have about 25% Net Income.

Now, which of your expenses or costs do you think are actually cost of your services? Are you recognizing direct costs properly or have you neglected them by chance?

If you are serious to understand how profitable your business is and how you can really grow your business, the profit is in the gross profits! Increasing your Gross Profit in an accurate and true way will reveal your business’ true profitability and potential!

Do you have more clarity now after reading the above tips? If yes, it’s time to increase your business profitability now to meet the green target line or go above and beyond!

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