Updated: May 14
Welcome back to the "All About P&L Statement" series. We will be discussing the cost of sales, or more commonly known as Costs of Goods Sold (COGS) in accounting. COGS is the expense incurred upon the sale of the business's goods and services. It is also commonly referred to as the Cost of Sales for service companies and resides just below revenue in the income statement.
Getting excited? Without further ado, let us embark on this exciting journey and do leave a like or comment!
TABLE OF CONTENT
What is COGS?
FIFO & AVCO Inventory Valuation Methods (Case Study)
Process & Job Costings
Cost of Sales
Gross Profit & Contribution Margin
Budgeting for COGS
The Economy of Scale & Learning Curve
WHAT IS COGS?
The cost of goods sold (COGS) is the cost of purchasing and producing the goods sold in manufacturing and merchandising company. COGS is recorded when the good is sold while the cost of unsold goods is recorded in the inventory.
Therefore, to understand the calculation of COGS, one has to understand how the value of inventory is calculated. When direct material, labour, overheads (depreciation, managerial and support, etc), and other inventoriable costs like in-freight are incurred, they are first recorded in the inventory account. Once the good has been sold, the cost is then transferred out of inventory and into COGS.
Sold inventory is recognized as COGS upon the sale of the product.
Raw material costs are recorded as Raw Material which is distinct from inventory.
Inventoriable costs such as in-freight costs are capitalized in inventory.
Selling and admin (SG&A) costs are recorded under operating expense (OPEX), NOT COGS!
There are several inventory valuation methods. There are commonly-used techniques such as First-In-First-Out (FIFO) and Average costing (AVCO) and the specific identification method which is suitable for companies to hold sufficiently distinct inventories. Under IFRS, the LIFO method of inventory valuation is prohibited.
The gross profit can be calculated after deducting the direct material purchasing, labour and overhead costs from revenue. Unlike raw material and inventory accounts which are asset accounts that are carried to the next reporting period, COGS measures the cost of merchandise or service sold during the financial reporting period. If a company has negative gross profits, it means that the firm is incurring losses for additional units produced.
FIFO & AVCO INVENTORY VALUATION METHODS
Adam is the manager of Bohari Fresh Inc., a merchandiser that imports and distributes organic fruits and vegetables. Over the past month, the cost of a popular brand of apples has increased significantly due to a weather event. Adam raised his concern on the increasing price of apples and the impact of FIFO and AVCO inventory valuation methods on the COGS and gross margin.
The FIFO method, as its name suggests, means that inventory is sold at a first-bought, first-to-get-sold basis. It has nothing to do with actual tracking of physical inventory. Assets with the oldest cost are included in COGS while ending inventory, which is presented in the balance sheet, is matched with the more recent purchase and/or production costs. The COGS under FIFO is $8,400, while inventory is valued at $2,200.
The AVCO method values inventory at its average cost. COGS and inventory value under the AVCO method are more consistent and less affected by price volatility. It is also suitable when the goods are homogeneous and nonperishable. The COGS under AVCO is $8,480 which is $80 higher than FIFO COGS, while inventory is valued at $2,120 which is $80 lower than FIFO inventory. Evidently, the sum of COGS and inventory is similar under both methods.
With increasing cost and everything else's equal, the COGS of AVCO is higher than FIFO, resulting in lower profitability and lower asset level.. If the business opts for FIFO, it results in lower COGS, higher asset level and higher profits without a corresponding increase in physical asset and cash. The inventory valuation method, thus, has a material impact on the presented financial performances.
PROCESS & JOB COSTINGS
The previous examples illustrates how a merchandising company calculates COGS and values inventory. But if the business produces homogeneous goods through a series of processes, the process costing method can be used to measure COGS and inventory for financial reporting.
For example, Bohari Fresh Inc. produces bottled orange juice.through 3 processes, 1) Juicing Station, 2) Mixing Station, and 3) Bottling Station. Afterwhich the finished products are transferred to the chiller and be readied for sale. Below is a simple illustration on how costs are transferred between processes and how inventory and COGS are calculated.
If the business creates products that are unique, managers and accountants can use the job costing system, which tracks jobs instead of processes. Each job then contributes to the eventual completion of the project. Costs incurred remained as WIP inventory until the job is completed, thereafter it is transferred to finished goods.
For example, Bohari Fresh Inc. was contracted to upgrade the facilities of its subsidiary. The product consists of 3 jobs, 1) Replace the flooring, 2) Replace the chiller, and 3) Install a drying machine. The below is a simple illustration on how each job contributes to the eventual completion of the project and how inventory and COGS are calculated.
More detail on the various costing methods will be presented in a later article on management accounting. So stay tuned!
COST OF SALES
Service, unlike inventory, is provided and consumed immediately. It does not have a physical presence yet its outcome can definitely felt. The direct cost of providing service is measured and recorded when the revenue is earned and direct labour costs typically occupy a higher percentage of the cost of sales (COS) for service businesses.
It is bad practice to lump the COS and other selling, general and administrative (SG&A) expenses together as it distorts the company's reported financial performances. Muddling up production, selling and administrative expenses make the accounting data less decision-useful and does not conform to the IFRS accounting standard.
For example, Sofia is a fruit consultant of Bohari Fresh Inc. She pitches for businesses (classified under SG&A), assists in the administration (classified under SG&A), and delivers consulting solutions to upstream producers (classified under COS). If she is paid $10,000/month and the month of March, she works for an approximate 200 hours, the hourly rate will correspond to $50/hr.
If the project is project-based and rendered over multiple reporting periods, gross margin can be calculated by deducting as-incurred COGS from the recognized revenue. For example, Bohari Fresh Inc, signed a deal with the farming cooperative to provide consultation to its producers over the span of 2 years. For the month of March, the firm recognizes revenue of $12,000. Service supplies and overheads amount to $2,000. The gross margin for the month will be $4,000 ($12,000 - $6,000 Direct Labor - $2,000 Direct Supplies and Overheads).
GROSS PROFIT & CONTRIBUTION MARGIN
For external users of the financial statement, the COGS is deducted from revenue to derive Gross Profit which gives an overview of how the business manages its production costs. As the gross margin varies widely with industries and sectors, an investor should view the gross margin in relation to the peers and industry average to yield meaningful insight.
When a company scores a relatively bad gross margin, it sends a negative signal to the market, which may cause its share price to decline, impair its ability to raise fund, and violate its covenant, giving its lenders the right to call for immediate full repayment of the remaining debt outstanding. That gives some managers the impetus to understate COGS to achieve higher profitability now at the expense of the future by upward-estimating the inventory value and hide recurring production costs in non-operating expenses.
Contribution Margin (CM) is a non-GAAP (generally accepted accounting practice) measure that is used by internal managers and accountants as a basis to make business decisions. The measure removes variable costs from revenue to arrive at an earnings before any fixed cost is deducted. It is a critical input to breakeven analysis, throughput accounting, etc, which will be discussed in a subsequent series on management accounting. Generally, a labour-intensive organization will have lower CM relative to a highly-automated corporation. Consequently, if one compares 2 peer firms in a similar industry, the level of CM can be indicative of the relative level of capital investment and automation.
For external stakeholders who do not enjoy the same level of access to sensitive production information but still need to forecast COGS for financial modelling purposes, we recommend first calculating COGS as a percentage of sales. If the percentage is consistent over past periods and there is no reason that suggests that the pattern is not repeating in the future, one can set the easily forecast COGS based on future revenue estimates. If the easy method does not work, one can still forecast using the 2methods.
I. Incremental Growth Method
This is also a relatively straightforward method. If the COGS exhibits consistent year-on-year growth, an incremental growth approach may be adopted by applying the compounded annual growth rate (CAGR) on current period to compute the next period COGS.
II. Linear Regression Method
The bottom-up regression is a relatively more sophisticated approach that can be done using Excel's Analysis Toolpak. Firstly, set the past COGS components such as direct material, labour, and overheads (typically disclosed in the footnotes) as the X-variables, past COGS as the Y-variables, and conduct a regression analysis to identify the multiple R-square. Multiple R-square suggests how much X can explain changes in Y and the higher the better. If the R-square is sufficiently high (eg. 70% and above), it suggests that we should be able to safely forecast the COGS based on future cost components estimates.
BUDGETING FOR COGS
Managers and accountants typically have more access to information for forecasting COGS for budgeting purpose. The process is intrinsically linked with the revenue estimate and starts with the number of units expected to be sold within the period. Its mechanics is best illustrated with a case study.
Adam expects Bohari Fresh Inc. to sell 5,000 premium grapes for the 3rd quarter. He refers to the bill of material to calculate the direct material cost and the standard operating procedure to compute the direct labour costs. Lastly, he estimates the periodic overhead costs for the quarter.
He arrives at $96,500 after adding the direct material cost of $36,500, the labour cost of $15,000, and 3 months of overheads valued at $45,000.
THE ECONOMY OF SCALE & LEARNING CURVE
The economy of scale is the proportion cost savings that arise from increased production. The higher base of quantity produced allows the fixed production overheads to be shared, lowering the per-unit fixed production overhead. The economy of scale can also ensue from purchasing activities because of bulk discount, the higher utilization rate of purchasers, and a more favourable bargaining position due to size
The learning curve hypothesizes that the more a worker performs a task, the better he gets. The learning curve is made possible through labour specialization and organization learning. The former free workers from distractions and allow them to perfect their craft while the latter encourages and facilitates the transfer of knowledge. Both effects enhance profitability and the effect can be observed by widening gross and contribution margins.