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

Accounting for unclaimed cash dividend

Lets start with an example. 

A company had 100000 shares outstanding (par value of Rs 1). The company plans to declare a 1:1 dividend. 

The following entry is made at the closure of financial statements

Provision for proposed dividend                                          100000

Appropriation to PL account                       100000

In the first quarter of the next financial year, the dividend is declared.

The entry is

Provision for proposed dividend                  100000

Dividend Payable                                                                100000

On the date of payment, the company is unable to pay a few shareholders amounting to Rs 10000, due to technical issues. 

The entry for the payment is

Dividend Payable                                        100000

Unclaimed dividend                                                             10000

Cash                                                                                   90000

And another entry for earmarking the fund for unclaimed dividend

Cash earmarked for  unclaimed dividend         10000

Cash                                                                                    10000

How Provisions and Contributions for Employee benefits is recorded.

PROVISIONS FOR EMPLOYEE BENEFITS

I am going to explain this in a simple manner. Provisions are required in defined benefits pan. Defined benefits, are estimates of expenses that has to be paid to the employees. Since they are estimates, they are provided for (provisions) in the balance sheet. Provisions for Gratuity, leave encashment are examples. 

There are two kinds of provisions for employee benefits that needs to be recorded by a company.

Short term provisions.

                       Short term provisions are quite simple to record. They are liabilities which are due to employees within a years time. Lets take a look at the entry for a short term provision.

 Employee benefit expense                   XXX

 Provision for Employee benefit                                  XXX

We do not need a separate fund for paying for these provisions, as they come under current liabilities.

Long term provisions.

                       Long term provisions are provisions estimated and recorded every year in anticipation of a lump sum payout to employees, when they retire, or when they complete the tenure required for availing the benefit. There are various methods used for estimating the long term liability to the company for these lump sum payments. Lets look into an example.

Company XYS Ltd  gives salary to an employee of 10000 per year. He is eligible to retire after 5 years with a gratuity of 10% of his last annual salary multiplied by the years of his service to the company. 

The company estimates a salary rise of 10% each year. 

His last year salary can be estimated as 10000 X (1.1)^5 = 16105

So the company will have to pay him 5 X 16105 X 10% = 8052.5 when he retires.

For this the company has to make a provision each year till he retires. 

For that the company divides 8052.5 by 5 and multiplies by the present value factor to obtain the estimate for the provision for each year. 

For year 1, year 2, year 3, year 4 and year 5  the provision estimate is calculated as 1099, 1209, 1330, 1464 and 1610. Along with that, some other costs are added such as interest costs and other costs. Now the provisions are increased to say 1500, 1750, 2000, 2250, and 2500. The entry for provisions for each year will be

Year 1

Employee gratuity expense                   1500

Provision for Employee gratuity                                  1500

Investments                                           1500

Cash                                                                              1500

Year 2

Employee gratuity expense                   1750

Provision for Employee gratuity                                  1750

Investments                                           1750

Cash                                                                              1750

Year 3

Employee gratuity expense                   2000

Provision for Employee gratuity                                  2000

Investments                                           2000

Cash                                                                              2000

Year 4

Employee gratuity expense                   2250

Provision for Employee gratuity                                  2250

Investments                                           2250

Cash                                                                              2250

Year 5

Employee gratuity expense                   2500

Provision for Employee gratuity                                  2500

Investments                                           2500

Cash                                                                              2500

Note that an equivalent amount of investments is done each year. Some companies do not make investments,but rather manage the expenses by insuring for the same.

Along with these expenses, additional expenses such as acturial Gain/loss, Gain/ Loss from Investments, and Actual settlements/ curtailments is charged to income statement each year.

CONTRIBUTIONS TO EMPLOYEE BENIFITS

These are contributions done by companies on monthly basis for future payments to the employees. The amount for these contributions are know to the company, so there is no need for any provisions. Which is why they come under defined contributions plan. They are recognized in Profit and loss as expenses.  Contributions to provident fund and superannuation are examples.

The entry for a contribution is


Contribution to PF/ Superannuation               XXX
Payables/cash                                                                                      XXX