Businesses constantly evaluate their operation and production practices to make sure they are running as efficiently as possible. One accounting tool which helps companies locate a weakness in their production strategies is a cost of goods sold schedule. This report is a valuable part of the income statement that provides tremendous insight into the net profit earned during a particular tax year or even a smaller period of time.
Sometimes referred to as a cost of sales report, the cost of goods sold schedule includes only the purchases and expenses that are directly necessary in the production of a product. Specifically, the schedule includes materials, overhead expenses and direct labor required to manufacture the product. It does not include any labor incurred to market or sell the product. For example, if a company manufactures bicycles, their cost of goods sold schedule could include items such as parts and the labor costs of those who actually put the bicycles together. It would not include the costs of distribution, and it also would not include the costs of any bicycles that did not sell during that reporting period. It is also important to note that cost of goods sold schedules are only prepared for companies that sell products. Businesses that produce only services do not require a cost of goods sold schedule.
In general, most COGS schedules are prepared the same way. The first entry is the beginning raw materials inventory plus the amount of additional raw materials purchased during the period. The actual raw materials used are subtracted to give the final raw inventory balance. Direct labor and overhead costs are added to give a total manufacturing cost. That number is used to calculate the costs of goods sold by starting with beginning finished goods inventory, adding the costs of goods manufactured, and subtracting ending finished goods inventory to find the true costs of good sold.
Why is the cost of goods sold schedule important to a business?
It is important to calculate the cost of goods sold annually based on the company’s fiscal year. It is necessary in order to prepare a proper business tax return, and it is also a useful tool to formulate strategies for the upcoming year. However, a cost of goods sold schedule can be prepared for shorter periods in order to provide comparison testing data throughout the year.
Having a good understanding of how the cost of goods sold schedule affects a business financially overall is critical because it usually represents the largest expense the company will incur. The expense of direct materials and direct labor costs has a direct correlation with the net profit of a company, and an increase in COGS will usually mean a decrease in the net profit. This can be observed in the company’s financial statements.
In some cases, it is possible for the costs of goods sold to increase even when sales are decreasing. This could be caused by many factors. However, one of the most common reasons is the quantity of materials purchased. The ability to buy in bulk will help to reduce the costs of goods sold and help to meet margins of lower sales numbers.
Another way to decrease the costs of goods sold when gross receipts are down is to attempt to lock the price of products for a long period of time. Being a great negotiator is key to securing positive price points for materials, and the longer those can be locked-in the better.
Automation of the manufacturing process can also be a big benefit of reducing COGS. Machines tend to be much more efficient and productive, and a fully-automated system can run all day long without a need to stop. This could help to increase the output of finished products while decreasing operating expenses to the company.