Proper calculation of Cost of Goods Sold (COGS) is important to brands because without understanding the cost of your goods once they have been sold, businesses wouldn’t have a clear picture of profits and losses. Maria Pearman, CPA, Principal at GHJ, sat down with Park Street University to provide a guideline of what is included in COGS, when a purchase becomes a cost of goods, and how this information can be used.
What is Included in COGS?
COGs are made up of three main components: raw materials and additives, direct labor, and manufacturing overhead.
Raw materials includes the ingredients that go into your liquid. Direct labor refers to the people that are manufacturing the product you sell and the value of their production labor. Manufacturing overhead includes things like rent and utilities, but could refer to the depreciation on your production equipment, as well.
When Does a Purchase Become a COGS?
As you spend money to buy things like grain, for example, that sits on your balance sheet as inventory. It’s not yet a COGS, it’s simply a swap of one asset (cash) for another asset (raw ingredients).
As you start the production process, the raw ingredients are going to then become a ‘Work in Progress’ or WIP. As you work through the production cycle all the way until you’ve actually bottled your product and have a finished case, it is still just a balance sheet item and has not hit your income statement as a COGS. It is only when you actually sell those goods that you can take the value and put it onto your income statement as COGS.
What are the Most Common Errors with COGS?
Pearman spoke of two main errors that she often sees on clients books. First, many clients only account for raw materials, the things that go into the liquid, when calculating cost of goods. This means they are leaving out either direct labor, manufacturing overhead, or both.
The other common error that Pearman encounters is clients expressing inventory or assets as COGS. Inventory cannot be calculated as COGS prior to the sale of a good.
How Can This Information Be Used?
COGS can be better used to understand how your brand’s profitability stacks up against industry benchmarks. It’ll help you understand if you are competing with your peers in a profitable way.
The information can also be used to evaluate your margin by SKU. Every good sold should have a particular margin associated with it and proper calculation of COGS can allow you to create some analytics that help drive proper managerial decision-making. Without accurate SKU-level data, it’s very hard to understand where you may be making money and where you may be losing money.
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