How to Get Accurate Cost of Goods Sold in a Manufacturing Business

An accurate calculation of the cost of goods sold is essential for manufacturing businesses. With this information, you can help them maintain profitability and make data-driven decisions.

In this article, we’ll explain how the cost of goods sold impacts manufacturing businesses, the primary drivers, how to calculate it, and some of the common challenges you may face when calculating the cost of goods sold.

Let’s dive in!

Understanding Cost of Goods Sold (COGS)

The cost of goods sold measures the direct costs incurred while producing the goods sold by a business. For manufacturing businesses, this includes the cost of raw materials, direct labor, and manufacturing overhead needed to produce finished goods.

Why is the Cost of Goods Sold in Manufacturing Important?

COGS is important for manufacturing businesses for many reasons.

First, it directly impacts the gross profit margin, which is a key indicator of a business’s financial health. It can be calculated by subtracting COGS from the total revenue and then dividing it by the total revenue. The higher the gross profit margin, the more revenue the business gets to keep after direct costs are accounted for.

Accurate COGS numbers allow you to help manufacturing businesses identify areas for improvement and cost savings. This is done by analyzing the pieces that make up the COGS, like:

Raw materials
Direct labor

Once you’ve spotted the area that is underperforming, you can help your clients make the adjustments.

Finally, calculating COGS is also helpful for tax compliance. Since, the IRS requires manufacturing businesses to report COGS on their tax returns, and inaccurate COGS calculations can result in penalties and fines.

Drivers for Cost of Goods Sold

There are two primary drivers of COGS in manufacturing businesses: materials cost and operations costing.

Materials Costing

Material costing is simple to understand and calculate. It is essentially the process of determining the cost of the materials used to produce a product in the manufacturing business. It represents the cost of the raw materials and supplies used in production, which is a key component of measuring COGS.

How you calculate materials costing will depend on the method your client uses for inventory costing.

Once you’ve done this, you can determine the true cost of producing a product and make help your clients make informed decisions about pricing and production strategies.

Operations Costing

Operations costing is a bit more complex. For this, you are calculating the cost of producing a product by assigning costs to specific operations or processes involved in production.

For example, let’s say:

Sarah works on gluing a chair for 2 hours and is paid 10 EUR/H
James is painting the chair for 1 hour and is paid 8 EUR/H

The time spent gluing and painting the chair would be calculated in the operations costing.

Operations costing helps manufacturing businesses determine the direct costs associated with producing a product, which is a key component of measuring COGS.

Like material costing, operations costing will help your clients make informed decisions about pricing and production strategies so that you can improve profitability.

How to Calculate Cost of Goods Sold

Once you’ve gone through the trouble of calculating the materials costing and the operations costing, all that’s left is to add them together to calculate the cost of goods sold.

After doing so, you can use it to help manufacturing businesses:

Make more informed decisions about pricing and production

Calculate your gross profit and gross margin

Challenges in Calculating Cost of Goods Sold

One of the primary challenges to calculating COGS is accurately determining the direct costs of producing a product as prices fluctuate, and there are often multiple steps involved in the production process.

Another common challenge is managing inventory levels and costs. Manufacturing businesses have to keep track of inventory levels and COGS on a regular basis to ensure accurate financial reporting. This can be a time-consuming process and require significant resources.

Accurately allocating indirect costs is another area that often causes trouble when calculating COGS. If these numbers are off it can lead to inaccurate financial reporting, which comes with its own set of challenges.

How to Avoid Challenges in Calculating Cost of Goods Sold?

Challenges in calculating COGS are common but the good news is there are plenty of ways to avoid them.

Here are our two best pieces of advice:

1. Implement a strong inventory management system. This will help you and your manufacturing clients accurately track inventory levels and costs and reduce the risk of errors and inaccuracies when calculating COGS.

Hint: point two can help you with this.

2. Use technology to automate processes. Manufacturing businesses and their accountants can use technology to streamline accounting, inventory, and production workflows. Katana is a cloud manufacturing platform that does just that.

It makes avoiding these challenges easier by calculating COGS for you. At that point, you are set up for success in calculating the impact of COGS on the manufacturing business!