Calculating Cost of Goods Sold in Manufacturing Efficiency is the lifeblood of any manufacturing company and the cost of goods sold (COGS) is among the most important measurement of successful businesses. What is it and how to calculate it? https://manufacturing-software-blog.mrpeasy.com/2019/03/26/calculating-cost-of-goods-sold-in-manufacturing/ https://www.mrpeasy.com/

1. CALCULATING COST OF
GOODS SOLD IN
MANUFACTURING

2. Efficiency is the lifeblood of any manufacturing company. If the processes and
procedures work smoothly and efficiently, profitability is enhanced. And if they
don’t, then profits may suffer.
But the necessity of efficiency isn’t confined to the factory floor and to
production equipment. A manufacturer’s efficiency must be comprehensive in
all areas in support of production as well. And nowhere is this more evident
than in calculating inventory to assess the Cost of Goods Sold (COGS).

3. What is Cost of Goods Sold?
Cost of Goods Sold, also known as Cost of Sales, is a key metric in determining a
company’s Gross Profit and Gross Margin. It measures only the direct costs
associated with the production of goods within a manufacturing company. For
accounting purposes, Cost of Goods Sold is listed under “current assets” on a
balance sheet. Current assets are goods expected to be converted to cash
within one year and include cash, accounts receivable, stock inventory, work in
progress inventory and other liquid assets.

4. What is Cost of Goods Sold?
To obtain an accurate Cost of Goods Sold, a company must have accurate
control of its inventory functions. This includes the physical or automated
functions for taking the inventory as well as the correct valuation of each
inventory segment. Most manufacturing companies usually have three different
inventory categories.
Raw Materials Inventory – This includes unprocessed materials used in
finished goods as well as components. Raw material costs are based on the
total “landed costs” of the goods.

5. What is Cost of Goods Sold?
Work in Process Inventory – This includes partially processed materials on the
factory floor and in various stages of “value add”. Work in Process calculations
will include labor added at each sub-processing level for material in progress. It
is therefore valued higher than raw materials but less than finished goods.
Finished Goods Inventory – This inventory includes all completed units ready
for sale of shipment.

6. Calculating Cost of Goods Sold
Calculating Cost of Goods Sold requires taking the beginning and inventory
value, minus ending inventory value plus factory overhead and direct labor. The
steps include:
1. Start with the Beginning Raw Materials Inventory value and add all raw
materials purchased during the selected accounting period. Then, subtract
the ending inventory value. This is the valuation of the direct materials used
in production.
2. Next, add the value of the direct labor and factory overhead. (Factory
overhead will include factory expenses like rent and utilities). Then, add this
sum to the direct materials from step 1. This is the Total Manufacturing
Costs.

7. Calculating Cost of Goods Sold
3. Using the beginning Work in Process (WIP) inventory, subtract the ending
WIP inventory value and add to the Total Manufacturing Costs in step 2.
This is the Cost of Goods Manufactured (COGM).
4. Finally, use the Finished Goods beginning inventory value and subtract the
Finished Goods ending inventory value and add this sum to the Cost of
Goods Manufactured. This is the total Cost of Goods Sold (COGS)

8. Calculating Cost of Goods Sold
As the calculation shows, all three inventory categories are used in determining
the Cost of Goods Sold and start with the beginning inventory valuation for
their respective categories plus the value of direct labor and factory overhead.
COGS may also be affected depending on the inventory costing method used
by the company such as First in First Out (FIFO), Last in First Out (LIFO), or
Average Cost Method. As companies have different levels of complexity and
scale, each will have to choose the method that works best for their business.

9. Why COGS is Important
Cost of Goods Sold is a metric that helps determine overall company financial
health. The COGS is subtracted from the company’s revenue to determine Gross
Profit. It can also be used to calculate Gross Profit Margin by dividing the COGS
by company revenue. The value of COGS is important for several reasons:
Helps to Set Profitable Pricing – In complex manufacturing systems, costing
each step of production is a challenge. As a result, a wrong calculation, or series
of calculations, can reduce the gap between COGS per unit and unit price.
Having accurate inventory counting and adhering to a strict COGS calculation
can help determine which products may be too low, or too high, and allows a
company to set appropriate pricing.

10. Why COGS is Important
Proper Taxation – Since COGS is considered an expense, a larger COGS will
result in a lower taxable income level. It is also important for companies who
are Make to Stock (MTS) and who carry stock finished goods inventory. In this
situation, the year end value of finished goods may be taxable as it is figured
into your COGS. Failure to adhere to proper inventory practices could result in
an over-taxation or an under-taxation, opening the company to audits and
potential fines.

11. Why COGS is Important
Tracking Profitability – COGS can be tracked as a trend over longer time
periods to gain insights and predictions into increasing or decreasing
profitability. This is useful for management in making decisions on where and
how to improve efficiency and improve inventory accuracy. It can also be used
by in-house analysts to determine strategy for the future as well as by investors
looking for upward or downward trends in overall profitability over time.

12. Areas of Caution in COGS
There are some negative factors that can impact a company’s COGS. These
factors can affect gross profit and are easily spotted by tax authorities and
investors and could harm a company’s credibility. Caution should be used to
avoid errors such as:
• Over-allocating manufacturing overhead.
• Overstating discounts to customers or returns to suppliers.
• Overvaluing WIP or on-hand inventory.
• Failing to write off obsolete inventory.

13. Properly Managing Cost of Goods Sold
Calculations
Regardless the type of accounting system or manufacturing tracking system
used, the most important thing to remember is to use the correct calculations,
account for inventory accurately, note the progression on the balance sheet in a
timely manner and understand the accounting inventory method used by the
company. Consistency will result in a more accurate COGS calculation and
will keep companies out of dangerous territory such as over and under-valuing
inventory.

14. Properly Managing Cost of Goods Sold
Calculations
At the same time, many small and medium sized companies still utilize manual
inventory tracking or, utilize legacy software, fragmented systems with siloed
data, and PC based spreadsheets to try and derive a COGS for their enterprise.
While consistency and meticulousness will help, there is a limit as to the degree
of accuracy these systems can achieve.
Given the importance of COGS calculations in defining Gross Profit and Gross
Margin for a company, software platforms exist that can help them do so with
improved accuracy. Many MRP and ERP systems can track the flow of material
through various production stages as well as act as a vital manager in the overall
supply chain

15. Properly Managing Cost of Goods Sold
Calculations
These platforms provide real time data and advanced analytics that can
help improve accurate costing in areas such as WIP calculation, manufacturing
overhead, and direct labor. And many have accounting software built in as a
native functionality or are agile and allow integration of respected accounting
software such as QuickBooks or Xero. And they are even agile enough to work
seamlessly with advanced RF inventory tracking through use of scanners and
other electronic equipment used to monitor, relive and track inventory at point
of use.

16. Properly Managing Cost of Goods Sold
Calculations
The value of an accurate COGS calculation can provide a company with insight
into profitability, allow long term strategic planning, improve pricing of products
and act as a guideline for taxes and investment. Whether done manually or
using software, the COGS calculation should be accurate and based on real data
to provide these things.

18. https://manufacturing-software-
blog.mrpeasy.com/2019/03/26/calculating-cost-of-goods-sold-in-
manufacturing/
https://www.mrpeasy.com/