In simple terms, the Chart of Accounts (COA) is how you organize the expense rows in your general ledger – be it in QuickBooks, NetSuite, or some other accounting software.
Specifically, the COA lists account numbers and account descriptions grouped by account types. A typical COA starts with balance sheet accounts (YTD assets and liabilities) and lists revenue and expense account numbers.
When your COA is well organized, you can quickly access metrics for financial reporting and generate financial statements with less effort.
What goes into COGS? What goes into SG&A? Where do you put payroll expenses?
These are all important considerations when you set up your COA.
Why are Chart of Accounts important?
A properly organized COA enables you to perform a robust business analysis and understand the financial levers at your disposal.
A poorly organized COA will prevent you from understanding how the variables of your business move together and may make detrimental decisions.
For example, a sales change affects accounts receivable and cash flow performance. You can use your COA to create customized reports that streamline analysis and decision-making.
The COA also impacts your financial accounting process. A well-organized COA speeds up bookkeeping and posting of GAAP accrual entries and other adjustments, making month-end reconciliations easier to complete.
And uniformity across departments when all stakeholders use the same COA
The main reason I prefer to organize the COA this way is to enable effective financial analysis & forecasting.
The Five Margin Levers in CPG
A CPG business has five main levers where your margins can change, and your COA should be organized to make those levers obvious and apparent.
1. Your gross sales deductions go up or down.
Chargebacks, refunds, discounts: All of these cash outflows take away from every dollar of revenue.
Categorizing these together and identifying them as a % of revenue allows you to say, 'if we cut our discounting in half, we can increase net income X%.”
2. The cost of producing products can change.
This factor - Cost of Goods Sold - is where people often start to disagree. I organize it by product costs (costs directly related to production) first and then by ‘other cost of goods sold.’
Taking this step enables proper financial analysis because your cost to produce one bottle of lotion can change if shea butter prices suddenly go up, but that doesn't necessarily mean you will be paying more for shipping costs, all else equal.
Understanding how your raw materials' cost impacts your business's earnings power is important. Raw material costs also impact inventory management and the decision to produce and sell a new product.
3. The cost of delivering products can change.
Like the ideology above, tracking all your fulfillment and operational costs is important. Because these costs are derived from the independent variable, 'orders,’ we group them into COGS as incurred upon selling a good.
Using this approach, COGS includes product costs and the variable costs incurred for fulfillment and operations. The more orders we fill, the more variable costs we incur.
This factor is a highly debated topic, and the reality is that if you are looking at this cost as anything else, you are mixing variables. It can muddy the waters as you conduct financial analysis.
For example, if you put shipping and fulfillment below the cost of goods and marketing and put it into an SG&A category, you have now mixed a variable expense with fixed overhead. It will inhibit you from identifying operating leverage in the business (discussed below).
So, USPS tends to hike rates yearly, but that doesn't mean your cost to produce that lotion increased by 3%. Isolate the variables to determine what is impacting the earnings of the business.
4. Marketing efficiency can change.
This point is fairly obvious and is why ‘Sales & Marketing’ deserves its entire category within the P&L COA.
Isolating marketing as a % of sales, MER, or ROAS, or however you choose to assess marketing efficiency, will quickly enable you to identify trends and seasonality within your business.
Before we can talk about the next section, we need to talk about and explain operating leverage.
We use this financial term to describe how sensitive a company's profitability is to changes in revenue. The answer to that question comes down to cost structure since the difference in revenue and profit is cost.
Companies with high fixed cost structures (SaaS, Manufacturing) can grow revenues without growing expenses as much, meaning the net income expands faster.
Companies with low fixed costs (CPG industry) generally scale expenses as revenue grows.
Companies with high operating leverage tend to do better in bull markets and periods of high growth, as profits grow faster than revenue. Still, because of the fixated nature of the cost structure, they tend to get wiped out much quicker in economic downturns.
Companies with low degrees of operating leverage have more agility and can shrink expenses if revenue goes down.
Let’s use gyms and fitness centers during COVID-19 as an example — a business model with a high degree of operating leverage.
You have super expensive fixed rent and a ton of fixed payments due for the workout machinery, and then one day, a virus breaks out, and everyone cancels their gym membership to try to adhere to social distancing.
Those rent and machinery payments don't go away - but the revenue does, and you’re screwed. Thanks for playing.
Now, a business with a low degree of operating leverage. Think CPG. If your revenue gets cut in half overnight, so do your product sold and shipping costs, and you can pull down your marketing expense with relative ease - all proportionally.
You might have to make a small round of layoffs. Still, generally, with half the revenue, you don’t need as many employees anyway so you can return to your normal profit margin, albeit at a lower scale here, with relative ease.
Okay, thank you for coming to my operating leverage TED Talk.
5. Fixed overhead can change.
This is a really important one, particularly in CPG, because this is where the operating leverage comes in. In CPG, compared to SaaS, manufacturing, etc.
Personnel & fixed costs are a small portion of the P & L, as we just said, so you should be looking to leverage the fixed costs as much as possible since there isn't much to begin with.
Think if you have 60% margins (pretty good) and a 2.5x MER (pretty good). That means COGS has already eaten 40% of your revenue; at 2.5x MER, that’s another 40% of your P&L.
Now, you have a 20% contribution margin, which could be higher but not bad. That leaves you with 10% of revenue to give to all the employees, insurance, rent, benefits, etc, to land at an ‘ok’ net income of 10%.
If you hire a handful of employees, you might go over that 10% threshold for a little bit, but hopefully, over time, your net margin expands up from 10% because as your business grows, you have enough employees to support that growth, until maybe it's time for another wave of hiring.
Because everything else grows as a true revenue function (i.e., $1 more in sales = $X more in shipping and marketing), you can increase revenue faster than you can increase headcount.
You can not, however, reduce your $ spent on product costs as you double revenue (practically speaking)
Notice how the green net income section expands with revenue growth.
Wrap-up: Getting Your Chart of Accounts Right
Have any questions as you’re setting up your COA or CPG finance in general? Follow me on X, and feel free to send me a message.
FAQ: Chart of Accounts
Would you consider "Other Marketing Expenses" included in a contribution margin calculation?
When we did the Airbnb IPO, we didn't include non-variable (brand) marketing expenses in 'CAC.'
So, excluding them is a very 'sell-side' way to look at it, but it gives you a better idea of true CAC. I would exclude it in a CAC calculation and consider it both in and out of a full CM calculation.
Drew Fallon is a seasoned CPG finance leader renowned for successfully raising $20m for Mad Rabbit Tattoo and leveraging his vast expertise from his tenure as a public equities analyst across operational metrics, financial modeling, and growth marketing.