Sunday, 19 March 2017

Cost of goods sold for a manufacturing company

We know that the basic formula for COGS is

 COGS = Cost of Goods Available for sale-Closing Stock 

 Cost of Goods available for sale.= Opening stock + Purchases

The concise formula therefore is

COGS = Opening stock + Purchases - Closing stock.


But this formula is so basic that it can be applied only to a trading company where nothing is manufactured.

Why?

Because manufacturing company has to account for Raw materials consumed, Work in Progress, Manufacturing over heads such as electricity, fuel, salaries and wages,stores and spares consumed.  transport to warehouse, etc. Also the company may purchase and sale stock without manufacturing it.

The formula of COGS for a manufacturing company is

Formula No 1

COGS = (1) Cost of Raw materials consumed 
           + (2) Purchase of Stock in Trade 
           + (3) Opening stock of WIP 
           + (4) Opening stock of finished goods 
           + (5) Opening stock of stock in trade
            - (6) Closing stock of WIP
            - (7) Closing stock of finished goods 
            - (8) Closing stock of stock in trade 
           + (9)  Manufacturing overheads 
           + (10) Cost of Stores and spares ( including packing materials) consumed
           + (11) Stock adjustments due to mergers and acquisitions 
           + (12) Other adjustments.

Formula No 2

COGS       = Cost of stock in trade sold + Cost of finished goods sold + Cost of Stores and spares ( including packing materials) consumed + Other adjustments.



Most of the balance sheet for Indian companies use the first formula, so that they can represent all the cost components of manufacturing separately.

So, if I am able to start from Formula 2 and slowly expand and reach Formula 1, my mission will be complete.

Now for simplicity sake, let us ignore the Cost of stock in trade sold, Cost of stores and spares (including packing materials consumed) and Other adjustments and focus on Cost of finished Goods only, because, majority of the components of Formula No 1, is present in the Cost of finished goods.

Now before we go further, we need to make a primary assumption, a kind of visualisation, of how the  journey of finished goods, from the purchase of raw materials to the final finished state happens.

For this purpose, we need to imagine that the manufacturing process happens in 3 stages in 3 separate areas of the same building as seen in the image below.




THE FINISHED GOODS AREA


In order to fully understand the concept let us begin at the finished goods area.

In the finished goods area, we manufacture the finished goods, stock them and then sell the finished goods according to the demand from the market.

By using the general formula for COGS, and a bit of thinking, we can accept that the Cost of finished goods sold is

Cost of finished goods sold = Opening stock of finished goods + Cost of manufacturing of finished goods -Closing stock of finished goods. (FORMULA A)

What we need to understand is, what all adds up to the cost of manufacturing of the finished goods.

In the finished goods area, we take the necessary WIP stock from WIP area, use necessary equipments, consumables, fuel and labour to convert WIP to finished goods, which then adds to the finished goods stock.

Cost of manufacturing of finished goods = Cost of WIP used + All the manufacturing overheads for converting WIP to finished goods. (FORMULA B)


THE WIP AREA


In order to find the Cost of WIP used, we need to understand what is happening in the WIP area.

In the WIP area, we source raw material from the raw material area and convert the raw material into WIP, add to the WIP stock and transfer the necessary WIP to the finished goods area.

By using the general formula for COGS, and putting a little spin on it, we can accept that the Cost of WIP used is

Cost of WIP used = 

Opening stock of WIP + Cost of conversion of Raw Material to WIP - Closing stock of WIP. (FORMULA C)


Now let's see, what all adds up to the cost of conversion of Raw materials to WIP.

In WIP area, we take the necessary raw material from raw material area, use necessary equipments, consumables, fuel and labour to convert raw material to WIP, which then adds to the WIP stock.

Cost of conversion of Raw Material to WIP = Cost of Raw material consumed + All the manufacturing overheads for converting Raw material to WIP. (FORMULA D)



THE RAW MATERIALS AREA


In order to find the Cost of Consumed, we need to understand what is happening in the raw materials area.

In the Raw Material area, we purchase and stock raw material, and then supply the necessary raw material to the WIP area for converting to WIP.

Here we cab use the general formula for COGS directly

Cost of Raw material Consumed = 

Opening stock of Raw Material + Purchase Of Raw Material - Closing stock of Raw Material. (FORMULA E)



COST OF FINISHED GOODS SOLD  (A+B+C+D+E)

Cost of finished goods sold = (4) Opening stock of finished goods + (3) Opening stock of WIP + (1) Cost of Raw material consumed  - (7) Closing stock of finished goods - (6) Closing stock of WIP + (9) Manufacturing Overheads  (FORMULA F)

Now,  the formula for Cost of finished goods sold component of Formula No 2 is complete. Now we have to add the formula for Cost of stock in trade, Cost of Stores and spares ( including packing materials) consumed, to Formula F and Other Adjustments.

COST OF STOCK IN TRADE

Now we need to understand that a manufacturing company also trades goods, which either they do not manufacture. This means that they purchase finished goods (which they do not manufacture), stock them and sell them in the market, just like a trading company. These kind of goods are called stock in trade.

So they account for the inventory of  stock in trade, just like trading companies do.

So by using the general formula for the COGS

Cost of Stock in trade = Opening stock of Stock in trade + Purchase of Stock in trade-Closing stock of Stock in trade. (FORMULA G)

COST OF STORES AND SPARES AND PACKING MATERIALS

When a company manufactures goods, they consume spares, packing materials  as well as items in stores. The accounting for the cost of stores, packing materials and spares varies from company to company. Either they diclose the cost right away, in a different head, or they include the opening and closing stock along with raw materials, or with the finished goods. 
                                   

STOCK ADJUSTMENTS DUE TO MERGERS AND ACQUISITIONS

During mergers and acquisitions, the stock of the merged or the acquired company may be added to the opening stock and closing stock of the Raw materials, WIP and finished goods, in the year of the merger and acquisition, Normally, they are disclosed separately. 

OTHER ADJUSTMENTS

I will add the cases for other adjusments later.



CONCLUSION

FORMULA No 2 to FORMULA No 1


Let us write down the FORMULA F again

Cost of finished goods sold = (4) Opening stock of finished goods + (3) Opening stock of WIP + (1) Cost of Raw material consumed  - (7) Closing stock of finished goods - (6) Closing stock of WIP + (9) Manufacturing Overheads  (FORMULA F)

Merging formula G to Formula F and adding the additional costs of Stores, packing materials and spares, Stock adjustments due to mergers and acquisitions, and other adjustments

we get

Cost of  goods sold = (4) Opening stock of finished goods + (3) Opening stock of WIP + (1) Cost of Raw material consumed  - (7) Closing stock of finished goods - (6) Closing stock of WIP + (9) Manufacturing Overheads + (5) Opening stock of Stock in trade + (2) Purchase of Stock in trade-(8) Closing stock of Stock in trade + (10) Cost of Stores and spares ( including packing materials) consumed+ (11) Stock adjustments due to mergers and acquisitions + (12) Other adjustments.

So we have successfully assembled all the components of Formula No 1 by expanding Formula No 2

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