If you really want to understand how your business is working, you need to understand gross margin. And if you want to have a meaningful and correct gross margin, you need to separate direct (COGS) and indirect (overhead) expenses. And the toughest and most crucial COGS (cost of goods sold) item is payroll.
It is surprising how few businesses actually take this step. Without it they really cannot know if their direct costs are too high or if their pricing is too low. Without this, you will be left in the dark and will probably make the mistake many companies make. You are likely to fix the wrong thing.
Before I explain how to split payroll, here is an important concept that needs to be addressed. Some people will disagree, but most agree with this:
Basic COGS Payroll Concept: All staff hired to do billable services should have their pay 100% allocated to COGS payroll. Anything they do that is “administrative” is really just part of the cost of having a billable person on the payroll. Training, administrative meetings, and paid time off should be viewed as part of the direct cost of having a billable person on staff and therefore should be included in COGS. There are exceptions to this rule, but we will save those for later.
Understated COGS generally leads to pricing that is too low. Pricing that is too low for a company’s cost structure is one of the most common causes of business failure. If pricing is wrong, growth will destroy a company. There is usually a fine balance between healthy and unhealthy business growth and COGS is the key to understanding where that line is.
First priority is to get COGS payroll split from overhead payroll. There are 4 ways to do this:
- Produce a departmental payroll – this is the ideal solution, but can be the most expensive. If you use an outside payroll processing company, they can do this for you at an extra charge. You may need to prepare time sheets showing where employee time is being spent unless you charge each person 100% to a single department.
- Journal entry split – this is actually the easiest solution, especially for smaller companies. Here you just run all payroll into a single payroll account in the accounting system. After the payroll is posted each month, manually compute how much of the payroll belongs to COGS and do a journal entry that reduces the payroll expense account (which is usually an overhead expense account) and add that amount to a COGS payroll account. This can be a quick calculation and quick journal entry done each month.
- Simple percentage split in Corelytics – this is a way to see roughly what your total COGS are and it lets the Corelytics give you a rough feel for gross profit and gross margin. This is not a good long-term solution, but is a quick way to get started.
- Monthly adjusting entries in Corelytics – this is similar to the split journal entry approach above, but done in the dashboard. You would only do this if (a) you wanted to test a “what if scenario” or (b) you don’t want to make changes to your accounting system. In Corelytics you can create adjusting entries that reduce overhead payroll and increase COGS payroll, or any other account for that matter. These amounts can be entered each month.
To make gross profit reporting meaningful, you should make this change for the preceding 24 months at a minimum – 36 months would be ideal. If you just start tracking this information in a new way and don’t change your history you will not be able to do meaningful trend analysis, and comparing your P&L to a prior period will be very misleading.
Once you get your COGS payroll split from overhead you are ready for the next step which is to split COGS payroll into separate COGS accounts for each line of business (LOB). This is the crucial next step in build a company that can grow and have precision steering. You can read more about COGS in my upcoming book – Pulse: Understanding the Vital Signs of Your Business. We are planning to release the book in the next few months.