Cost of Goods Sold in Manufacturing – How to Calculate COGS
The many cost-oriented KPIs in manufacturing accounting constitute some of the most important financial metrics for manufacturers and distributors. In this post, we look at the function and relevance of one such KPI – the Cost of Goods Sold.
What is the Cost of Goods Sold?
The Cost of Goods Sold, or COGS is a financial metric that depicts the total costs incurred with manufacturing or procuring any finished goods that were sold within a given financial period. COGS essentially represents the expenses that a company needs to recover when selling an item in order to break even. These include all costs directly tied to producing finished goods like the costs of raw materials and components, direct labor, packaging and shipping, as well as factory overheads.
COGS does not include indirect overhead costs – general business expenses such as utilities, administrative and marketing costs, leases and rent, depreciation, etc. It also excludes the cost of manufactured or acquired goods that were not sold within the financial period and stayed in the finished good inventory.
For manufacturers and distributors alike, keeping a keen eye on COGS depends to a large extent on a good overview of one’s inventory. This is a prime reason why rigorous inventory management practices and accurate inventory tracking are essential in ensuring a company’s financial health.
How to determine the Cost of Goods Sold?
In essence, calculating the Cost of Goods Sold is quite straightforward. First, the total value of all finished goods at the beginning of a financial period is added to The Cost of Goods Manufactured or COGM. COGM is a metric depicting the total manufacturing cost of all finished goods within a financial period. The total cost of finished goods that were not sold within the financial period is then subtracted from the sum to arrive at COGS. It is worth mentioning that for distributors or wholesalers that do not manufacture their own products, COGM is replaced simply with Purchases in the formula.
COGS = Beginning Finished Goods Inventory + Cost of Goods Manufactured – Ending Finished Goods Inventory.
Delving into the calculation in a bit more detail, we can see that the COGS equation includes all three basic inventory types – the raw materials, WIP, and finished goods inventories. The extended COGS calculation goes as follows:
- Add together the values of the beginning raw materials inventory and purchases for the financial period. Then subtract the value of the ending raw materials inventory. This will return the Direct Material Cost.
- Add direct labor, packaging and shipping, and factory overheads. This will return the Total Manufacturing Cost (TMC).
- Add together the values of the beginning WIP inventory and TMC. Then subtract the value of the ending WIP inventory. This will return the Cost of Goods Manufactured.
- Add together the beginning finished goods inventory and COGM. Then subtract the value of the ending finished goods inventory. This will return the Cost of Goods Sold.
COGS and inventory valuation
Being largely dependent on the value of inventory items, the Cost of Goods Sold varies by which inventory valuation method a company uses. There are four main inventory valuation methods that each affect COGS in their own way, also making them instrumental in leveraging net income.
- In the First In, First Out, or FIFO method, the first items purchased or manufactured get sold first. Since raw material prices tend to rise over time, the first procured items are generally cheaper. This usually lowers COGS and concurrently raises net income.
- The Last In, First Out, or LIFO method, on the other hand, will prioritize selling the last purchased or manufactured items first. Following the above logic, COGS will generally be higher with LIFO than with FIFO, leading to a relative decrease in net income over time.
- The Weighted Average or Average Cost method takes the average price of all stock items to account in the valuation of sold goods. This will have a stabilizing effect on COGS as raw material price hikes will not introduce cost discrepancies.
- Finally, the Specific Identification method uses the specific cost of each stock item to calculate the ending inventory value and thence, COGS, as precisely as possible.
With the exception of Specific Identification, all of the abovementioned methods provide cost estimations for sold inventory. In theory, COGS should include the cost of all sold inventory. In practice, however, companies often do not know for sure which items specifically were sold during a financial period. Since COGS directly affects gross profit, manufacturers may prefer to use methods that return a lower COGS in order to report higher profits.
Read more about Manufacturing Accounting
The importance of COGS
In accounting, the Cost of Goods Sold is an expense appearing in the income statement. It is used to determine a company’s gross profit by subtracting its value from total revenue. It is also needed for calculating a company’s gross margin – the funds available to pay for fixed expenses and income tax, which in turn is required to determine a healthy markup. Gross margin is calculated by dividing gross profit by revenue. As the primary cost of doing business, COGS also informs net income.
It is important to bear in mind, however, that COGS does not come without its limitations. Since it is a complex calculation with many variables, errors in calculation or methodology may result in misstated net income and tax liability. It is also quite easy to manipulate by over-allocating factory overhead, failing to write off obsolete items, altering stock levels, etc. To avoid legal ramifications or unethical practices, what to include in COGS should be determined as precisely as possible.
Next, let us look at some of the prime reasons why keeping a close eye on COGS is a must for manufacturers.
- Helps to set profitable pricing. In manufacturing, especially in complex workflows, costing each step of production can be a challenge. A wrong calculation can reduce the gap between COGS per unit and unit price. Having in place accurate inventory counting and adhering to a strict COGS calculation can help determine which products may be priced too low or too high. This allows a company to set appropriate pricing.
- Proper taxation. Since COGS is considered an expense, a larger COGS will result in a lower taxable income level. This is especially important for make-to-stock manufacturers who carry large finished goods inventories. In this situation, the year-end value of finished goods may be taxable as it is figured into COGS. Improper inventory practices could result in over- or under-taxation, opening the company to audits and potential fines.
- Managing profitability. COGS can be tracked as a trend over longer time periods to gain insights into profitability. This is useful for management to make decisions on where and how to improve efficiency and improve inventory accuracy. It can also be used by in-house analysts to plan future strategies, as well as by investors looking for upward or downward trends in overall profitability.
Cost Of Goods Sold in manufacturing systems
Whereas the Cost of Goods Sold equation is theoretically quite straightforward, ensuring precision can be challenging in practice. What to specifically include in manufacturing costs and factory overheads? Is the chosen inventory costing method applicable? Is WIP inventory accounted for accurately? Is the adopted accounting system taking all moving parts into consideration? These key aspects need to be double and triple-checked.
The importance of a well-implemented inventory management system cannot be overstated in addressing the above-mentioned issues and ensuring financial health and legal compliance for your company. Very small companies with limited manufacturing complexity might still make do with spreadsheets and periodic inventory systems for their cost accounting purposes. Dedicated inventory management systems or manufacturing ERPs, however, go far beyond simply keeping stock organized. These solutions utilize a perpetual inventory system and keep all stock movements and costs automatically synchronized from purchase orders all the way to shipping to customer.
Many of these software providers are tailor-made for the complex requirements of modern SME manufacturers, combining affordability with cutting-edge functionality. For example, with MRPeasy, accuracy in cost accounting is assured thanks to enhanced inventory and production tracking tools, and procurement management functionalities. A standard accounting module helps keep tabs on the books while seamless integrations with respected financials software like QuickBooks and Xero make sure all finances are always under control.
- The Cost of Goods Sold (or COGS) is a financial metric that depicts the manufacturing or acquiring costs of all finished goods that were sold within a financial period.
- COGS is important for manufacturers and distributors in determining gross profit and gross margin, assigning a healthy markup, as well as leveraging net income.
- An accurate COGS calculation depends on consistent inventory management practices, efficient stock tracking, and adopting a suitable inventory valuation method.
- Due diligence needs to be exercised in allocating expenses into COGS, as inflating inventory costs or missteps in stock levels may result in financial difficulties or legal ramifications.
- While calculating and keeping track of COGS is theoretically possible with a pen-and-paper approach, it is hugely simplified by adopting a capable inventory management software solution.
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