COGS (COST OF GOODS SOLD)

In this post it will be explained the concept COGs, cost of goods sold. The COGs is the direct manufacturing cost of a product or service (only manufacturing! logistics is not considered in COGs).

COGs (Cost of Goods Sold). This item, depending on the cost accounting system used by the company could be considered as: (1) Direct cost (expense that only takes into account the manufacturing costs of the product/service, either variable or fixed), (2) Direct variable cost, taking into account only the manufacturing costs per unit sold.

Usually any manufacturing process uses 3 types of resources: (1) R1, raw materials, (2) R2, operator, (3) R3, machinery. If we estimate the usage of R1, R2 and R3 per product/service manufactured, the COGs per unit manufactured can be calculated.

EXAMPLE 1: COGs of HAMBURGERS

Imagine that we sell hamburgers, and the ingredients used in 1 hamburger (bread, lettuce, beef, tomato, etc cost €1 (R1).

The monthly salary of the person that prepares the hamburgers including social security paid by the company is €1,000 per month and works 160 hours per month (9,600 minutes). This “operator” employs 5 minutes of time to prepare the hamburger, therefore the cost of personnel per hamburger manufactured would be 5 minutes*€1,000/9,600 minutes=€0.5208 (R2). Japanese define the cost of the operator per minute as “souchin” (souchin=€0.1041 per minute).

In order to prepare the hamburger, different machineries are used, and the company has estimated that one machinery usage, called as “Cost per shot, cps” is €0.04791 and preparing 1 hamburger requires 10 usages of the machinery (“number of shots per hamburger”). Therefore the cost of machinery would be cps*number of shots=€0.04791*10shots=€0.4791 (R3). In this example the COGs=R1+R2+R3=€1+€0.5208+€0.4791=€2 per hamburger sold.

The COGs is usually provided in percentage over selling price excluding VAT, in this case it would be €2/€10=20%. This calculation is very important as we can compare the COGs of our company against others and analyze causes of deviations. Imagine that the competitors COGs on average is 15%. Why do we have a COGs that is +5% greater in absolute terms? The reason is because our supply procedures/ingredients are more expensive, do we pay higher salaries or our technology is not efficient? As the sales plan for the fiscal year is 60,000 units sold, the yearly COGs= €2*60,000 hamburgers=€120,000.

EXAMPLE 2: COGs of MANUFACTURING A MOBILE PHONE

Let’s calculate the COGs of manufacturing a mobile phone. We now the following data:

The manufacturing process of 1 mobile phone employs:

  • R1-Operator. The cost per hour of the operator is €10 and 1 mobile phone requires 404 minutes of operator (the time of operator required to manufacture 1 mobile phone is called Standard Time, SST). The operator cost per minute is called souchin, in this case: €10/60 minutes=€0.1667 per minute of operator.
  • R2-Raw materials. The materials that are used in manufacturing one mobile phone are defined in the BoM (“Bill of Materials”), that clearly defines the number of items that comprises the mobile phone. In this case, the BoM is: x1 Screen (€60), x1 Motherboard (€68.63), x1 Battery (€40). The total cost of the raw materials employed in manufacturing 1 mobile phone is: €168.63 per unit.
  • R3-Machinery. The machinery usually is a robot, that is calle “A/I”, automatic insertion robot. Imagine that we have invested €1 million in the robot, then the capex undertaken by the company is €1 million, and the value fo the robot (“Gross Book Value”) is €1 million. If the estimated lifespan of the robot is 10 years, then the Depreciation and Amortization (D&A) is €1 million/10 years= €100,000 per year. In addition, we know that during the lifespan of the robot, the total number of shots that the A/I can do is 100 million, the we know that every time the A/I robot makes a “shot”, it will cost: €1 million/100 millions shots=€0.01 per shot. This metric is called cost per shot. We know that in order to manufacture 1 mobile phone, 10,117 shots must be made.

Once we know the cost of the resources, and the units of each resource used in manufacturing one mobile phone, we can calculate the COGs of producing 1 mobile phone:

  • R1-operator=COGs of operator=Souchin*SST=€0.1667 per minute * 404 minutes= €67.33 cost of operator per mobile phone produced.
  • R2-raw materials=COGs of raw materials=The sum of all the raw materials defined in the BoM=€168.63 per mobile phone produced.
  • R3-machinery, A/I robot=COGs of robot=cost per shot*number of shots=€0.01 per shot * 10,117 shots = €101.17 cost of A/I robot per mobile phone produced.

Then we can calculate the TOTAL COGs per unit of product manufactured, in this case, per mobile phone manufactured and sold.

TOTAL COGs per unit=COGs operator+COGs Raw materials+COGs A/I robot=€67.33+€168.63+€101.17=€337.17 per unit.

If we know the yearly sales forecast (let’s assume 120 million units), or expected number of mobile phones that will be sold in one fiscal year of company operations, the yearly COGs will be: COGs per unit*yearly sales forecast=€337.17 per unit*120 million units expected to be sold=€40,455 billions.