Why Your COGS Is Wrong — And How to Fix It in Manufacturing Accounting

Cost of Goods Sold (COGS) is one of the most vital fundamentals for any manufacturing business. Not only does it simply appear as a line in your income statement, it affects your gross margins, pricing decisions and your inventory valuation.

Several businesses often seem to be thriving with high sales and strong production numbers but are actually underperforming. With an incorrect COGS in manufacturing accounting, you may end up underpricing products resulting in hefty losses.

In this blog, we will highlight manufacturing COGS calculation errors, and how to calculate COGS in manufacturing correctly.

What Are Manufacturing COGS And How To Calculate COGS In Manufacturing

For companies operating in the retail or trading space, COGS is relatively simple; Opening Inventory + Purchases – Closing Inventory.

However, in manufacturing, the calculation is slightly complex. This is because you don’t only deal with finished products, you’re manufacturing them. This means that you deal with several things including but not limited to raw materials, Work in Progress (WIP), direct labor, manufacturing overheads etc. The complexity of calculating manufacturing COGS leaves room for error.

To avoid dealing with incorrect COGS in manufacturing accounting, you need to understand the flow of costs through out the manufacturing process. There are three inventory categories:

1. Raw materials: The items needed to produce the finished goods
2. Work in Progress (WIP): These are semi-finished goods.
3. Finished Goods: The products that have completed the manufacturing cycle.

The first step is to calculate total manufacturing costs, that are direct materials used, direct labor and manufacturing overhead.

You now have to calculate the Cost of Goods Manufactured as follows:

Beginning WIP + Total Manufacturing Costs – Ending WIP

Lastly, calculate the COGS: Beginning Finished Goods + Cost of Goods Manufactured – Ending Finished Goods

Any errors in the initial steps will carry forward into your final COGS.

Common COGS Mistakes in Manufacturing

1. Ignoring Manufacturing Overhead Allocation Errors: While many manufacturers accurately track and apply direct material and labor costs, they often fall short in carefully allocating manufacturing overhead. Manufacturing overhead includes factory rent, insurance and utilities, equipment depreciation, indirect labor costs such as supervisor salaries and machine maintenance costs.
2. By ignoring manufacturing overhead allocation errors, product costs can end up either understated or overstated.This can result in incorrect pricing and manufacturing decisions such as aggressively selling when costs are understated, reducing production for goods that seem to be unprofitable due to overstating of costs, and distortion of financial statements. Consider allocation methods based on machine hours or direct labor hours, or for more accuracy, use Activity-Based Costing (ABC).
3. Misclassification of Direct and Indirect Costs: Misclassifying costs leads to inconsistencies in your costs. The results of this error are incorrect pricing decisions, misleading profit margins per product, and poor budgeting decisions. The best possible solution for this is to set forth a rule of thumb as to what qualifies as direct labor, direct material and overheads while the same should be properly communicated to the accounts department.
4. Wrongly Documenting Work In Progress: Work in progress becomes messy when you do not keep track of semi-finished goods and use guesswork to determine completion percentages. To overcome this problem, make use of production reports to track completion percentages, implement regular stock counts, reconcile WIP periodically and also ensure production and finance teams are well-aligned to ensure costs are correctly recorded.
5. Inventory Valuation Affecting COGS: The method of valuing inventory will directly affect your COGS. In inflationary times, the use of First-In First-Out (FIFO) will lead to lower COGS but higher profits. The use of Last-In, First-Out (LIFO) would result in higher COGS but lower profits. It’s extremely important to apply your valuation method consistently to ensure COGS represent the true picture. Remember, when dealing with inventory, always perform regular stock counts and immediately investigate any variances.
6. Disregarding Scrap and Waste: You may experience costing inaccuracies if you don’t track scrap or forget to allocate normal waste to overhead. Abnormal scrap should be expensed while normal scrap should be built into your product-costing model. Oftentimes, scrap can also be sold so having a proper track of waste can be important to generate some cash flow.
7. Using Outdated Standard Costs: While many manufacturers use standard costs for materials, labor and overheads, updating them for rises in wage rates or material costs are equally important. By neglecting such changes, variances will grow and actual costs will be much higher than budgeted.
8. Production and Accounting Teams Are Not Interconnected: Lack of communication between these two departments will lead to data gaps. They need to be interconnected. Interconnectivity doesn’t end with these two departments, it’s a business-wide cooperation required. The sales team need to communicate to the production team of the standards required while the accounts team would have to budget accordingly to ensure availability. To solve this, hold monthly cross-departmental reviews and meetings to ensure all department managers are aligned and aware of the existing business cost environment.

The Downside Of Incorrect COGS in Manufacturing Accounting

1. Pricing Errors: If COGS are lower than actual, businesses may end up selling at lower prices which can result in lower margins or losses while overstating COGS can lead to higher selling prices and loss of business to competitors. With incorrect COGS, some products seem like top performers but are actually unprofitable.  
2. Cash Flow Forecasting Inaccuracies: Manufacturing COGS calculation errors may affect your gross margins, the value of your inventory and the tax that you pay. Unreliable cost assumptions can distort the accuracy of your cash budgets.
3. Incorrect Tax Returns: With incorrect COGS, business owners may end up incorrectly filing their taxes. You may end up overpaying or even underpaying your taxes if profits are understated, which can result in huge penalties and audits.

How To Know If You Have An Incorrect COGS in Manufacturing Accounting

• Inconsistent gross margins or individual product margins compared to industry standards or past returns
• Unreasonable inventory valuations
• Profitable sales are not converting in to higher cash inflows for the business

How To Fix Manufacturing COGS Calculation Errors

1. Review Your Cost Classifications: Try to find errors or inconsistencies in the cost classifications currently used, the overhead allocation methods or inventory valuation methods.
2. Perform a Sample Analysis: Choose any product currently being manufactured and recalculate its cost. Compare it with the budgeted costs to find and analyze any variances.
3. Overhead Allocation Method: Check if the cost drivers used are still relevant and accurately reflects actual usage. If the factory is now more machine intensive, the accurate cost driver would be machine hours.
4. Strong Inventory Controls: Implement weekly or monthly reconciliations of Work In Progress inventory and raw material inventory to ensure all valuations are accurate.
5. Integrate Production With Accounting Data: This can be done by using ERP systems and production software. Consider automation to increase traceability and reduce human error.
6. Activity-Based Costing: ABC costing is specifically designed for complex production lines. ABC is useful for companies that have multiple products with varied batch sizes. Overhead are normally assigned based on activities such as quality inspections or machine setups. ABC costing makes use of more relevant cost drivers but it is not as simple to implement.
7. Consult a Professional: Consider talking to a professional accountant and hiring them for more accurate costs figures.

There is much more to having accurate COGS than just filing the correct taxes. Accurate costs lead to better pricing decisions, understanding of the actual product profitability, make or shut decisions, more effective cash management and better informed decision-making.