BUS202: Principles of Finance

COGS is difficult to forecast due to the sheer amount of expenses included and differing methods of estimating each.

TERMS

• allocate

  To distribute according to a plan.

• overhead

  Any cost or expenditure (monetary, time, effort or otherwise) incurred in a project or activity, which does not directly contribute to the progress or outcome of the project or activity.

Cost of goods sold (COGS) refer to the inventory costs of the goods a business has sold during a particular period. Costs include all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition. Costs of goods made by the business include material, labor, and allocated overhead. The costs of those goods not yet sold are deferred as costs of inventory until the inventory is sold or written down in value.

Because costs of goods sold is a major expense for most companies, it is an extremely important input to a forecast of the income statement. A miscalculation or faulty estimation can be amplified drastically, causing a vastly different forecasted amount of income than what will actually come to pass. Specifically, underestimating the costs associated with goods to be sold can cause the forecasted income to be much higher than what it actually will be, and vice versa. Also, because cost of goods sold is such a broad input, encompassing many separate expenses with different methods of estimating each, it becomes difficult to accurately forecast all phases.

Components of COGS

Parts, Raw Materials, and Supplies Used

Most businesses make more than one of a particular item. Therefore, costs are incurred for multiple items rather than a particular item sold. Determining how much of each of these components to allocate to particular goods requires either tracking the particular costs or making some allocations of costs. Parts and raw materials are often tracked to particular sets (e.g., batches or production runs) of goods, then allocated to each item.

Labor and Associated Costs

Labor costs include direct labor and indirect labor. Direct labor costs are the wages paid to those employees who spend all their time working directly on the product being manufactured. Indirect labor costs are the wages paid to other factory employees involved in production. Costs of payroll taxes and employee benefits are generally included in labor costs, but may be treated as overhead costs. Labor costs may be allocated to an item or set of items based on timekeeping records.

Overhead of the Business Allocable to Production

Determining overhead costs often involves making assumptions about what costs should be associated with production activities and what costs should be associated with other activities. Traditional methods attempt to make these assumptions based on past experience and management judgment as to factual relationships. Activity based costing attempts to allocate costs based on those factors that drive the business to incur the costs.

Variable production overheads are allocated to units produced based on actual use of production facilities. Fixed production overheads are often allocated based on normal capacities or expected production. More or fewer goods may be produced than expected when developing cost assumptions (like burden rates). These differences in production levels often result in too much or too little cost being assigned to the goods produced. This also gives rise to variances.