Demystifying COGS: Understanding the Cost of Goods Sold
Basic BOM and COGS
For those new to the manufacturing sector or simply moving across functions, numerous financial terms and acronyms can seem daunting to the uninitiated – one of those being COGS, or Cost of Goods Sold. In part one of this two-part series, we’ll break down the concept of COGS and why it matters.
COGS is a fundamental financial metric businesses use to determine the cost of producing the goods they sell to customers. FACTURE routinely builds models for food and beverage, biotech, and nutraceutical organizations; however, other products can include electronics, clothing, or even services. Maintaining a line-of-sight to profitability is a key focal point many new companies overlook when starting and developing a product.
In essence, COGS represents the direct costs tied to the production [or acquisition] of the items a company sells. These direct costs can include:
Raw Materials: The expenses incurred to obtain the materials needed for production- for example, the cost of flour, chocolate chips, and sugar for a cookie manufacturer.
Labor: The wages paid to employees directly involved in making or assembling the products. Examples include factory workers, artisans, or even software developers in a tech company.
Overhead: This is a combination of all other costs related to the production of the finished product – related to the production process – such as rent, machinery maintenance, gas, electricity, and other utilities.
Tolling or facility usage rates: If the manufacturing strategy includes contract manufacturing, a “tolling” fee will be added to each unit produced, or a “facility usage” fee will spread across all units produced in a given timeframe.
Shipping and Logistics Costs: The expense of getting the finished products to the distribution centers or customers, and in some models, the average cost of storing the product until it reaches the end customer.
Why Do COGS Matter?
Understanding the Cost of Goods Sold is essential for several reasons:
Profit Calculation: COGS is critical in calculating a company's gross profit. Gross profit is the revenue generated from selling goods minus the cost of producing or acquiring those goods. It provides a clear picture of how much money the company is making from its core operations.
Taxes: Many tax authorities require businesses to report COGS for tax purposes. Accurate COGS figures help minimize tax liability.
Financial Analysis: Investors, lenders, and analysts use COGS to assess a company's financial health and efficiency. A high COGS relative to revenue can indicate inefficiency in production processes or sourcing strategies.
Pricing Strategy: Understanding the cost of goods sold is crucial for setting competitive prices. If your COGS is high, pricing your products too low could lead to losses, while pricing them too high could deter customers.
How to Calculate COGS?
Calculating COGS is relatively straightforward. Here's the formula:
COGS = Beginning Inventory + Purchases during the Period - Ending Inventory
The above terms are defined as:
Beginning Inventory: The value of inventory at the beginning of the accounting period
Purchases during the Period: The cost of additional inventory acquired during the period
Ending Inventory: The value of remaining inventory at the end of the accounting period
In summary- it’s not quite that easy. FACTURE has spent hundreds of hours developing a proprietary model and methodology to facilitate commercialization and accurately predict [and optimize] COGS for emerging companies and existing manufacturers. We will cover this methodology and its value in Part II of this series.
