Optimize Your Cost of Goods Sold in the Beverage Industry

Bringing your dream beverage to life is only one of the hurdles set for those entering the beverage industry. You might have the tastiest drink in the world, but that won't matter unless you can learn to successfully manage your business expenses.

Your beverage will be the heart of your brand. As the business owner, it's your job to make sure you know the ins and outs of your product. Understanding your Cost of Goods Sold (COGS) is an important step in this process. It is key to maximizing your production budget and figuring out where you could be reducing costs without compromising on quality.

In other words, once you know what goes into creating your beverage, including the breakdown of its per unit cost, you will be better equipped to determine your priorities and implement meaningful business solutions.

It may sound a bit overwhelming, but we're here to help you get started.

What is the "Cost of Goods Sold?"

Before you do anything, you should make sure you know what "Cost of Goods Sold" means. The Cost of Goods Sold (COGS) refers to any direct costs, including labor, that are associated with the production of goods sold by a company.

In the beverage industry, your COGS calculation will likely include the costs of ingredients and raw materials (including packaging) needed to create your beverage and ensure its quality, as well as associated manufacturing, freight, and warehousing expenses. Indirect expenses, like those attributed to distribution, marketing, and sales, are excluded from your COGS.

It sounds obvious, but prioritizing where you could — or should — be cutting costs is vital to your success and longevity in the industry. Your COGS calculation can help you gauge how financially successful your business is, because it directly determines gross profit.

For example, if your company has a higher COGS, it could mean you're spending too much on inventory costs. This knowledge can be used to make your business more profitable, because reducing your product expenses means your company can increase its net income.

How do I evaluate my Cost of Goods Sold in the beverage business?

There are lots of ways to answer this question, and they all depend on the unique nature of your business and your beverage product.

In the beverage industry, for a variety of reasons, most businesses have little control over the manufacturer of their raw materials and finished product, so they become extremely dependent on those two components. And the fact that they're never executed in the same place poses an added challenge.

Your COGS will then be unique to your business, determined by your beverage's composition and packaging, as well as the availability of raw materials, manufacturers, freight, and warehousing with capabilities which can reasonably meet your product's individual needs. That being said, it is possible to discuss COGS from a beverage industry specific perspective, which should give you the direction you need to hone in on your personal business needs.

There are four main cost categories you should consider when evaluating the overall COGS for your beverage product. These expenses include:

• raw materials and ingredients;
• manufacturing;
• logistics;
• warehousing.

Raw materials and ingredients costs

Remember, we're dealing with food. Everything has an expiration date (or shelf life), so you will need to consider microbiological and organoleptic changes that can impact the quality of your product's taste, odor, color, and texture.

Over the course of a couple of months, the taste profile of your stored ingredients may naturally start to change, meaning you'll need to decide whether or not you'll want to sacrifice quality and use them in your finished product. Either decision will have an associated risk: if you dispose of your ingredient inventory, you take a loss; but if you choose to use old ingredients in your beverage, you may risk compromising its shelf life and quality — or even its overall reputation.

Of course, for smaller businesses one of the most difficult considerations involves buying Economies of Scale, which involves proportionate cost savings gained through an increased volume of production. But when your company is small, you're typically going to want to stick with Minimum Order Quantities (MOQs), which generally leave you with a higher per unit cost and surplus inventory.

The best way to understand how this works is through "The Hot Dog & Bun Scenario." If you've ever hosted a barbecue, you know that it's impossible to buy equivalencies of hot dogs and buns. One package of hot dogs yields 10, but one bag of buns yields only 8. Because your use isn't equal, you're going to end up with leftover raw materials — in this case, hot dogs.

The same can be said about manufacturing in the beverage industry: the MOQs for your drink's raw materials will never yield the exact amount of finished product you will want to make, meaning you'll always be stuck with an inventory of raw materials, like ingredients or packaging.

Some ways to decrease your raw material costs include:

• buying in larger quantities;
• forecasting out your needs;
• contracting out pricing.

Let's use Southwest Airlines' fuel hedging program as an example. In 1994, Southwest Airlines began long-term contracts that set 20-30 percent of their jet fuel at a lower price by forecasting out their needs. When the global economy sent crude oil prices skyrocketing in 1998, at least a portion of the airline company's fuel source was protected by their guaranteed contract price. This allowed them to keep their costs 25-40 percent lower than competitors over the course of the next 5 years. In turn, this stabilized their profit margins, reducing some of the losses that other airlines had been suffering. By 2008, Southwest Airlines had forecasted out nearly 70 percent of its fuel needs with longer term, cost-stabilizing contracts. While the beverage sector and airline industry are wildly different, the business strategy used in this example remains relevant.

As you may be well aware, buying ingredients in large quantities is not always possible for beverage entrepreneurs and small start-ups with limited capital, freight, and warehousing — not to mention those ingredients could go to waste if your business doesn't have the production capacity or market share needed to benefit from a larger order. That's why forecasting out your needs and developing long-term contracts can provide a more appropriate solution, stabilizing your cost commitment and allowing you to offer a friendlier price point for your product in the marketplace. In other words, you'll be committing to purchase a volume equivalent to large order purchasers, but it might be over a period of months versus all at once, making it easier to deal with as you focus on the growth of your business.

Of course, there are pros and cons to everything. The primary risk here falls on your ability to accurately forecast out your product needs and overall business' success. Because you'll have to guarantee to buy over a certain period of time, you are going to have to pay for it all eventually. If you commit yourself to buying too much or if your business falls under, then you're going to be in trouble.

In addition to the cost of your ingredients, you also have to think about their availability and proximity to other key stops in your production journey. Think about where your materials are coming from: How stable is that area? How tied to agriculture are your raw materials and ingredients? What political and regulatory conditions will you need to navigate in order to get your materials? What other risks are posed in sourcing ingredients from this supplier or location?

Take Chinese tariffs for example. China manufactures raw materials and other products for the United States because their labor costs are comparably cheap. If tariffs hit, the costs of those imported ingredients are going to rise. In the beverage sector, we are heavily dependent on the availability of raw materials like petroleum and corn, and these products are both extremely sensitive to Commodity Indexes: if a bushel of corn goes up, so will commercial and industrial ethanol; and if petroleum costs increase, then anything dependent on plastic (such as packaging) is going to go up too.

To put it another way, if Madagascar gets hit by a tsunami, then vanilla prices will rise. If you've been sourcing all of your vanilla from Madagascar, then you're going to be unable to manufacture your product without taking a hit to gross margin with an unforeseen increase in COGS — and that's if you can even get ahold of the materials at all. These are some of the possibilities you'll want to consider when calculating the cost of the raw materials and ingredients needed to produce your beverage.

Manufacturing expenses

Contract packing (or co-packing) presents another Economies of Scale situation. As your production volume increases, your co-packing price per unit will decrease.

But there are different types of co-packers, so your costs may vary. For example, smaller co-packers may allow you to produce lower quantities of your products, but the cost per unit is likely going to be more expensive. You'll probably be able to get a better cost per unit price if you order in larger quantities from a bigger co-packer; but as with raw materials, your beverage is going to have a shelf life, and if you have too much product too soon, it's more likely to go to waste.

As you start to grow, your production scale will have to grow as well. If you want to reduce your manufacturing costs and can sustain moving larger volumes of product, then you should consider a high-volume co-packer. Until then, forecasting and contracting can help reduce your manufacturing expenses.

Location is also important when it comes to manufacturing costs. If all of your distribution takes place in New York, then you probably won't want to manufacture in San Diego: you'll only end up shelling out thousands of extra dollars on freight to move materials and product across the US. On the other hand, the union labor and tax structure in New York can present you with additional challenges, so even if you are selling there, you may decide it best to produce outside of New York. With so many factors in play, you'll need to think carefully on how you go about manufacturing your beverage.

Logistics costs

Again, proximity is going to be important here, but other cost considerations will be dependent on the types of goods you're moving. As a beverage company, you're typically going to be dealing with dry goods — like packaging, casing, and plastic wraps — which must travel from one manufacturer to your co-packer, so there is a freight cost involved there. Second, you'll have raw materials that will need to be shipped from your supplier to your co-packing facility. Finally, you're going to have finished product that will need to be sent as inventory to your warehouse or distributor. All of this movement is going to have a cost. And if you are importing or exporting materials, you may end up paying more.

When selecting your freight carrier, you'll need to consider proximity as well as their shipping capabilities: Does your finished product or raw materials have to be refrigerated? Can they be shipped on a bumpy rail car? Are there concerns with pressure? Does it make sense to produce in a certain location if you have to move your product so far? This all has a cost. As the business owner, you'll have to determine if it's worth the price tag.

If you are shipping a wine for example, you don't want to let it go over a certain temperature — but things can get really hot on trucks. You've got the friction from the truck moving that generates heat, as well as the outside elements to worry about, and it's typically not going to be an air-conditioned space. If it gets too hot, you risk corks popping and product spilling. You run into the same problem if it's too cold. Let's say you're shipping your wine from northern Minnesota. Instead of getting really hot, it going to be freezing. That's why it might be best to ship on refrigerated trucks which will keep your product at a stable temperature, no matter what the outdoor conditions may be — but again, that is going to have a higher cost.

Warehousing expenses

Simply put, warehousing is your cost for storage. You're going to need warehousing for your raw materials, including ingredients and packaging, as well as your finished product.

Remember The Hot Dog & Bun Scenario? You can't make anything with 100% output or input, so you will have leftovers from a production — whether its cans, ingredients, or other materials. You'll have to find a place to put it, and it will come at a cost.

Just like freight, you'll need to think about location and other considerations, like if you want to keep it in a temperature-controlled space or elsewhere. Balancing proximity with storage amenities is going to be difficult, so be sure to explore your options and consider how forecasting and contracting out can reduce your costs.

Last-minute lessons in optimizing your Cost of Goods Sold

It's easy to get wrapped up in the excitement of marketing and sales, but don't let it distract you from exploring areas in your production process where you could be saving.

First, take a look at what your most expensive items are, and start with those for cost reduction. For example, if you're paying a premium for co-packing and you haven't had conversations with alternative co-packers, then you may not be aware of other pricing structures and opportunities. Same goes for every other component of your COGS breakdown. Set a target for yourself and prioritize what is most important to you and your business.

Know your product and your process. And know your customer base too, because that's going to say a lot about where you should be manufacturing, shipping, and distributing, which could make a huge difference between making and losing profit.

Yes, it's a big, complicated topic. And it's difficult to do everything at once — but it can be done! Take those small steps, put in the time and research to understand your COGS, and you will be that much closer to successfully managing the finances of your beverage business.

Written by Aaron Parker, Chief Operating Officer, Flavorman

When you're ready to talk about your idea for a breakthrough beverage, give us a call at (502) 273-5214 or get started with our web form, here.

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