For manufacturers, understanding the concept of COGS is crucial for business success. But what is COGS?
COGS, or the cost of goods sold, is more than just a financial metric — it’s a powerful tool that provides deep insights into your operational efficiency and profitability.
By accurately tracking and analyzing the direct costs associated with producing goods, manufacturers can make informed decisions on:
- Pricing.
- Production processes.
- Inventory management.
In this guide, you’ll delve into manufacturing COGS to get a thorough understanding of why it’s important and how to calculate it for your own operations.
Let’s get started.
What is cost of goods sold?
COGS (cost of goods sold) represents the direct total costs incurred when producing goods. This includes the cost of materials used to create the product and the direct labor costs involved in production.
COGS is a crucial metric for most businesses as it directly impacts profitability and is essential for financial reporting and tax purposes.
Why is the cost of goods sold in manufacturing important?
COGS is vital in manufacturing as it directly impacts your:
- Profitability.
- Pricing.
- Tax compliance.
- Inventory management.
By subtracting COGS from revenue, you can determine your gross profit, a key indicator of your business’ financial health. As a result, you can set the most competitive prices to ensure optimal profitability.
Also, COGS plays a crucial role in inventory management. By analyzing COGS in relation to your inventory levels, you can improve inventory turnover and efficiency to reduce your carrying costs and boost cash flow.
Not to mention, accurate COGS calculations are essential for tax reporting and optimizing deductions.
Basic COGS formula
The basic formula for calculating COGS is:
COGS = Beginning inventory + Purchases – Ending inventory
This formula is most effective when inventory constitutes the majority of your COGS. For service-based businesses or those with high labor needs, calculating the cost may require you to include additional factors.
Drivers for cost of goods sold
Materials costing
Materials costing includes the cost of raw materials used in production. This encompasses:
- Direct materials: Primary components used in the product.
- Indirect materials: Supplies used in production but not directly part of the final product.
Operations costing
Operations costing involves two main categories:
- Direct labor: Wages of workers directly involved in production.
- Manufacturing overhead: Indirect costs such as factory rent, utilities, and depreciation of equipment.
Inventory valuation
Inventory valuation methods can significantly impact your COGS calculations. Common methods include:
- FIFO (First-In, First-Out): Assumes oldest inventory is sold first.
- LIFO (Last-In, First-Out): Assumes newest inventory is sold first.
- Average cost: Uses your average inventory cost across all items.
Note that your method of choice affects your reported COGS and, consequently, profit margins.
What is COGM?
Cost of goods manufactured (COGM) represents the total cost of manufacturing products and transferring them into finished goods inventory. It includes:
- Direct material cost.
- All labor expenses.
- Manufacturing overhead costs.
COGM vs. COGS
While related, COGM and COGS are distinct. COGM is used to calculate your ending work-in-process (WIP) inventory and is an input for determining COGS.
The biggest difference between them is that:
- COGM focuses on production costs for a specific period.
- COGS represents the cost of goods actually sold during that period.
Total manufacturing cost (TMC) and its differences
Like COGM, your total manufacturing cost (TMC) includes all costs associated with production. The key difference between TMC and COGM is that TMC doesn’t account for changes in work-in-process inventory.
How to calculate the cost of goods manufactured
The COGM calculation is typically used for a specific accounting period, such as a month or a year. Its basic formula is:
Beginning WIP (work-in-process) inventory + Total manufacturing costs – Ending WIP inventory
You can break this out a little further with this formula:
Beginning WIP inventory + Direct materials + Direct labor + Manufacturing overhead – Ending WIP Inventory
Your beginning inventory represents your total cost value of work-in-process (WIP) inventory at the start of the accounting period.
If you don’t have an ending inventory, it means all products started during the period were completed, and your ending WIP inventory would be zero. If you’re calculating COGM with an unknown ending inventory, you can estimate your historical percentage and apply that to your starting inventory.
Example calculation of cost of goods manufactured (COGM)
Let’s consider a furniture manufacturer with the following data:
- Beginning WIP inventory: $10,000
- Direct materials: $100,000
- Direct labor: $50,000
- Manufacturing overhead: $60,000
- Ending WIP inventory: $30,000
COGM = $10,000 + $100,000 + $50,000 + $60,000 – $30,000
So, for this example, the manufacturer’s COGM would be $190,000.
Linking COGM to COGS
Once you’ve calculated your COGM, you can incorporate it into your finished goods inventory metric. Here’s the formula to calculate COGS using COGM:
COGS = Beginning finished goods inventory + COGM – Ending finished goods inventory
Your manufacturing COGS is much easier to calculate once you have your COGM, and it decreases the risk of oversight. Breaking down your COGS calculation into smaller parts is a smart way to ensure that your costs and inventory accounted are accurate.
How to avoid challenges in calculating cost of goods sold
Here are five ways to avoid challenges when calculating manufacturing COGS:
- Maintain accurate inventory records through automatic and manual checks.
- Consistently apply inventory valuation methods across all manufacturing processes.
- Regularly reconcile inventory counts with financial records.
- Use appropriate accounting software for tracking costs, like QuickBooks.
- Stay informed about industry-specific accounting standards.
Key takeaways
Overall, a thorough understanding of cost of goods sold (COGS) and its calculation is essential for manufacturers to make informed pricing decisions and drive overall business success.
Remember that:
- The basic COGS formula is: Beginning inventory + Purchases – Ending inventory.
- COGM focuses on production costs, while COGS represents the cost of goods sold.
- Accurate inventory valuation and cost tracking are essential for correct COGS calculations.
Tracking COGS is only the first step. Once you know your costs, it’s time to understand how those costs of producing generate profits over time.
See how Method gives you key insights into your manufacturing business in real time.
Manufacturing COGS FAQs
Does COGS include the cost of goods manufactured?
Yes, COGS includes the cost of goods manufactured for products that were sold during the chosen period.
How can I track my COGS?
To track COGS, you should implement an effective inventory management system that accurately records purchases, production costs, and inventory levels throughout the accounting period.
Is COGS considered an expense?
Yes, COGS is considered an expense on your income statement. It’s subtracted from revenue to calculate gross profit.