Many businesses expense supplies as they purchase them. This makes the income statement pretty simple, with revenues at the top less expenses equals income. Manufacturing companies, on the other hand, buy many different products and maintain inventories of them to track when more product must be bought.
While it would be easier to expense these products as they are purchased, it would not present accurate financial statements at year (or month) end nor would it help keep track of inventory. The only way for such a company to know when it is out of a certain product would be constantly counting what remains.
What is Cost of Goods Sold?
Cost of goods sold (or COGS) makes it easier on a company to not only keep track of how much of each product remains but also exactly how much revenue they truly have. To put this in an actual example, let’s assume that Company A makes nail sculptures and buys boxes of nails, which it expenses as they are bought.
A buys a full pallet (6 boxes of 1000 nails each) every time it purchases the nails for a total discounted cost of $1,000. It takes 60 nails to create one sculpture. During the month, 4 sculptures are sold at $50 each ($200 gross revenue). Company A’s income statement for the month will show a loss of $800 (1,000 expense – 200 revenue), but is that an accurate representation?
Company B also makes nail sculptures and buys the exact same amount of nails, which are added to inventory (asset on the balance sheet). Assuming B also sells 4 of the same sized sculptures for $50 each. What is the bottom line on B’s income statement?
Using cost of goods sold, those four sculptures required 240 nails (60 nails per sculpture X 4), which actually cost $40 ($1,000 divided by 6,000 nails multiplied by 240 nails). So Company B’s income for the month was $160 (200 – 40). B also knows exactly how many nails remain in its inventory.
To make the math a bit easier to understand, take it step by step:
- 6 boxes of nails = 6,000 nails at a total cost of $1,000.
- $1,000 / 6000 = .16667 cents a nail
- 1 sculpture uses 60 nails, so 6000 / 60 = 100 possible sculptures to be sold
- 60 X .16667 cents = $10, which is the cost of making one sculpture
- 4 X $10 = $40, which is the total COGS
- 4 X $50 = $200, which is the amount received for sold sculptures.
- $200 - $40 = $160 Net income for the month
- 60 X 4 = 240 nails used during the month
- 6000 – 240 = 5760 nails remaining in inventory
- 5760 X .16667 or $1,000 - $40 COGS = $960 remaining inventory on the balance sheet
Using COGS is More Efficient than Manually Counting Inventory
Inventory tracking can also be automated with any number of available commercial software, but it can easily and cheaply be maintained using a multi-page Excel spreadsheet (or a database if that is preferred). Using formulas and macros make Excel a great choice, especially for those who are used to the application.
Cost accounting is actually one of the more exciting aspects of accounting, especially when numerous items go into the same product. COGS is called variable expense, while overhead (rent, utilities, payroll, etc) are considered fixed expenses. To truly use a full cost accounting system, everything must be subtracted from the cost of making a product to determine its per unit cost.
Cost Accounting is Defining a Product's Per Unit Cost
Continuing with the above simple example of one sculpture costing $10 in nails, let’s also assume the company is the owner’s garage. No extra overhead, but he pays a neighborhood kid $10 an hour to help melt the nails. If it takes 5 hours to complete this task, $50 would need to be allocated to all manufactured sculptures.
If an average of 2 sculptures can be finished during those 5 hours, $25 would be added to the cost of each one. In addition if an A/C is used to cool the garage to enable them to work inside, and it cost $100 a month, the total amount would be allocated to all sculptures created during that month.
So what does that do to the bottom line? For company A, it results in a larger loss of $1,000 ( -$800 - $100 (paid to helper for 2 days of work) - $100 for A/C).
Company B’s income would also take a hit and end the month with a loss of $40 (160 – 100 – 100). This is why cost accounting is so valuable.
Variable Plus Allocated Fixed Expense equals Per Unit Cost
Allocating all costs across the board allows the manufacturer to know how much he has to sell a finished product for in order to break even. Anything beyond that would be profit. B would need to figure up how many sculptures can be created during the month, not how many he actually sells.
B sold 4, but let’s say he was able to manufacture 8 during the month. It would still cost him $25 per sculpture for the helper to melt the nails, but the $100 A/C would be allocated over all 8, which equals $12.50 fixed cost per sculpture. This would result in a total cost per sculpture of $47.50. So he would need to make sure to sell each sculpture for more than that amount.
Why is there a loss for the month? All of the fixed cost of the A/C is in the current month. Accruing half of it in the following month would give the income statement a more accurate income of $10.00. See below for breakdown:
- $160 COGS income - $100 labor - $50 accrued utilities = $10 net income or per unit as
- $50 revenue - $10 COGS - $25 labor - $12.50 utility = $2.50 X 4 sculptures sold = $10
Accounting is very versatile in how income and expense is represented. The IRS just expects that whatever way is chosen, it must be consistent. The next cost accounting article will further explain how to use Excel in keeping track of inventory.
Judith Lee - Judith has been a writer for over two decades. She is also a blogger and book/movie reviewer.
