Manufacturing Cost of Goods Sold – How to Calculate COGS

The many cost-oriented KPIs in manufacturing accounting make up some of the most important financial metrics for manufacturers and distributors. In this article, we'll look at the role and relevance of one of these KPIs: Cost of Goods Sold.

What is Cost of Goods Sold?

Cost of Goods Sold, or COGS, is a financial metric that represents the total costs incurred in the manufacture or acquisition of any finished product sold within a given financial period. COGS essentially represents the expenses that a company needs to recoup when selling an item to break even. They include all costs directly related to the production of finished products, such as the costs of raw materials and components, direct labor, packaging and shipping, as well as factory overhead.

COGS does not include indirect overhead: business overheads like utilities, marketing and administrative expenses, leases and rent, depreciation, etc. It also excludes the cost of goods manufactured or purchased that were not sold during the year and remained in finished goods inventory.

For both manufacturers and distributors, control of production costs is highly dependent on a good overview of inventory. This is one of the main reasons why rigorous inventory management practices and accurate inventory tracking are essential to ensure the financial health of a business.

How to determine the Cost of Goods Sold?

At its core, the Cost of Goods Sold calculation is fairly straightforward. First, the total value of all finished products at the beginning of a financial year is added to the cost of production, or COGM. COGM is a metric that represents the total cost of manufacturing all finished products within a financial year. The total cost of finished products that have not been sold during the year is subtracted from the sum to obtain the cost of production. It is worth mentioning that for distributors or wholesalers that do not manufacture their own products, the COGM is simply replaced by Purchases in the formula.

COGS = Beginning inventory of finished goods + Cost of production – Ending inventory of finished goods.

Going a little deeper into the calculation, we can see that the COGS equation includes the three basic types of inventory: raw materials, inventory in progress, and finished goods. The expanded COGS calculation is as follows:

1. Add the values ​​of the beginning inventory of raw materials and the purchases for the year. Next, subtract the ending inventory value of raw materials. The result is the Direct Material Cost.
2. Add direct labor, packing and shipping charges, and factory overhead. The result is the total manufacturing cost ( Total Manufacturing Cost – TMF ).
3. Add the beginning WIP inventory and TMC values. Then subtract the ending WIP inventory value. The result is the cost of production.
4. Add the beginning inventory of finished goods and the costs of production. Then subtract the ending inventory value of finished goods. The result is the Cost of Goods Sold.

COGS and inventory valuation

Relying heavily on the value of inventory items, Cost of Goods Sold varies depending on the inventory valuation method a business uses. There are four main methods of inventory valuation, each of which influences the cost of goods sold in its own way, so they are also critical in driving bottom line.

• In the FIFO (First In, First Out) method , the first items purchased or manufactured are sold first. Since the prices of raw materials tend to rise over time, the first items purchased are usually cheaper. This often lowers production costs while increasing bottom line.
• On the other hand, the LIFO (Last In, First Out) method gives priority to the sale of the last items purchased or manufactured. Following the above logic, production costs will generally be higher with the LIFO method than with the FIFO method, which will lead to a relative decrease in net income over time.
• The Weighted Average or average cost method takes into account the average price of all stock items in the valuation of goods sold. This will have a stabilizing effect on COGS, as commodity price increases 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 therefore the COGS, as accurately as possible.

With the exception of Specific Identification, all of the methods mentioned provide estimates of the cost of inventory sold. In theory, the COGS should include the cost of all inventory sold. In practice, however, companies often do not know for sure which specific items were sold during a financial year. Since COGS directly affects gross profit, manufacturers may prefer to use methods that result in lower COGS in order to report higher profits.

The importance of COGS

In accounting, Cost of Goods Sold is an expense that appears on the income statement. It is used to determine a company's gross profit by subtracting its value from total revenue. It is also necessary to calculate a company's gross margin, that is, the funds available to pay fixed expenses and income tax, which in turn is necessary to determine a healthy profit margin. Gross margin is calculated by dividing gross profit by revenue. As the primary cost of doing business, COGS also reports net profit.

However, it is important to note that COGS is not without its limitations. As this is a complex calculation with many variables, calculation or methodology errors can lead to misreporting of net income and tax liabilities. It's also pretty easy to manipulate by over-allocating factory overhead, not writing off obsolete items, messing with stock levels, etc. To avoid legal ramifications or unethical practices, it must be determined as precisely as possible what to include in the COGS.

Here are some of the top reasons manufacturers should keep a close eye on COGS.

• Helps set profitable prices. In manufacturing, especially in complex workflows, calculating the cost of each production step can be challenging. A miscalculation can reduce the difference between the COGS per unit and the unit price. Having an accurate inventory and strictly following the production cost estimate can help you determine which products are priced too low or too high. In this way, the company can set the right prices.
• Adequate taxation. Since COGS is considered an expense, a higher COGS will translate into a lower level of taxable income. This is especially important for manufacturers who make make-to-stock and have large inventories of finished goods. In this situation, the year-end value of the finished goods may be taxable, as it is included in the COGS. Improper inventory practices could lead to over- or under-taxation, exposing the company to audits and possible fines.
• Profitability management. COGS can be followed as a trend over longer time periods to gain insight into profitability. This is useful for management to make decisions about where and how to improve efficiency and improve inventory accuracy. It can also be used by internal analysts to plan future strategies, as well as by investors looking for upward or downward trends in global returns.

Cost of goods sold in manufacturing systems

Although in theory the cost of goods sold equation is quite simple, in practice it can be difficult to ensure its accuracy. What specifically to include in manufacturing costs and factory overhead? Is the chosen method of calculating the cost of inventories applicable? Are inventories in progress correctly accounted for? Does the accounting system adopted take into account all the moving parts? These key aspects should be double and triple checked.

The importance of a well-established inventory management system in addressing the above issues and ensuring the financial health and legal compliance of your business cannot be stressed enough. Very small companies with limited manufacturing complexity may still make do with spreadsheets and periodic inventory systems for their cost accounting. However, dedicated inventory management systems or manufacturing ERPs go far beyond simply keeping stock organized. These solutions use a perpetual inventory system and automatically keep all stock movements and costs in sync, from purchase orders to customer shipment.

Many of these software providers are tailored to the complex requirements of modern SMB manufacturers, combining affordability with cutting-edge functionality. For example, with MRPeasy , cost accounting accuracy is ensured thanks to enhanced production and inventory tracking tools and purchasing management functionalities. A standard accounting module helps keep track of the accounts, while seamless integrations with top financial programs like QuickBooks and Xero ensure all finances are always under control.

Main aspects to take into account

• Cost of Goods Sold (or COGS) is a financial metric that represents the manufacturing or acquisition costs of all finished goods that were sold within a financial period.
• COGS is important to manufacturers and distributors when determining gross profit and gross margin, allocating a healthy profit margin, and leveraging net income.
• An accurate COGS calculation depends on consistent inventory management practices, effective inventory tracking, and the adoption of a proper inventory valuation method.
• Due diligence must be exercised when allocating expenses to COGS, as inflating inventory costs or getting stock levels wrong can lead to financial difficulties or legal ramifications.
• Although calculating and tracking production costs are theoretically possible with pencil and paper, they are greatly simplified by adopting an inventory management software solution.