How to Calculate Cost of Goods Manufactured
Every business owner must know and understand every aspect of their company, including the key metrics that help determine how well the business is fairing.
Business owners must know their income or expenditure, loss, profit, duction capacity, finished goods inventory account, raw materials inventory, WIP inventory (beginning WIP inventory and ending WIP inventory), and how to calculate COGM value, company’s net income, raw material inventory and the company’s total production costs.
Every manufacturer must understand, track, and interpret one business aspect: the Cost of Goods Sold (COGM). Unlike retailers, manufacturers have more inventory categories such as finished goods, work in process, and raw materials, contributing to the cost of goods manufactured and the cost of goods sold.
Let’s get started.
What is the Cost of Goods Manufactured?
Cost of Goods Manufactured (COGM) is a common accounting term used in managerial accounting. It refers to the total manufacturing cost a company incurs to manufacture products and turn them into finished goods inventory for sale during an accounting period.
COGM is used to determine whether their production costs are high or low than their generated income or revenue.
The cost of goods manufactured (COGM) calculates the total value of the progress inventory considering the total manufacturing cost incurred to produce the finished products for retail. After the calculation, the COGM value is then transferred to a final inventory account.
Manufacturing costs involved in the COGM include direct labor, factory overhead, and other manufacturing-related expenses.
How to Find Cost of Goods Manufactured or Goods Produced (Calculating COGM)?
To find the total cost of goods manufactured or production costs (calculate COGM) during the accounting period, you need to pay attention to the beginning work in process (WIP) inventory account and the ending work in process (WIP) inventory account. In other words, to calculate cost-effectively, the beginning WIP inventory and ending WIP inventory must be given the appropriate attention.
You can calculate the cost of goods manufactured (COGM) by adding the direct labor and indirect costs associated with production to the beginning WIP inventory; after this, you deduct the ending WIP inventory from the total manufacturing cost. In other words, subtract the ending WIP inventory from the total manufacturing costs incurred and beginning WIP inventory to get the cost of goods manufactured.
Direct Materials Used + Direct Labor Used + Manufacturing Overhead + Beginning WIP Inventory – Ending Work in Process WIP Inventory = COGM.
These three primary components make up any business's total manufacturing cost.
Direct Materials (DM)
Direct materials refer to all the raw materials used to produce the finished product or in its final form.
You can calculate Direct materials by adding the beginning raw materials to the purchases made and subtracting that total from the ending raw materials.
The Formula to calculate Direct Materials is:
Total Direct Material Costs = Beginning Direct Materials + Direct Materials Purchased – Ending Direct Materials
Direct labor refers to an organization's labor cost in preparing, assembling, and manufacturing its goods with raw materials. It is included in production costs and total manufacturing costs.
To calculate direct labor, you have to calculate the direct hourly labor rate and the direct labor hours.
Manufacturing overhead refers to the indirect costs that a company incurs during production over a specific period. It involves all indirect expenses related to production. E.g., Indirect labor used and indirect materials used.
Manufacturing Overhead Rate = Overhead Costs / Sales x 100
Example calculation of Ben’s Funiture Company’s Overhead Rate:
If Ben’s furniture company has a monthly indirect manufacturing cost of $20,000 and the company does $200,000 in monthly sales revenue, the overhead percentage is:
MOR = $20,000 / $200,000 x 100 = 10%
Therefore, 10% of Ben’s monthly revenue will be servicing the company’s overhead rate.
A high rate indicates that the company’s manufacturing operations may not be utilizing the resources available as efficiently as they should. On the other hand, a low rate points towards effective and efficient resource use.
An Example of Cost of Goods Manufactured (COGM) Calculation in Action
Let’s use Ben’s furniture company as an example in calculating cogm. The furniture manufacturer incurs the following expenses:
- Direct Materials: $9,500
- Direct Labor: $4,000
- Manufacturing Overhead: $20,000
- Beginning WIP Inventory: $10,000
- Ending WIP Inventory: $4,000
The formula for calculating the Cost of Goods Manufactured (COGM) is:
COGM = Direct Materials Used + Direct Labor Used + Manufacturing Overhead + Beginning Work in Process Inventory – Ending Work in Process WIP Inventory
COGM = $9,500 + $4,000 + $20,000 + $10,000 – $4,000
COGM = $39,500
How is COGM related to COGS?
The COGS refers to the total money a company spends on labor, materials, and overhead costs related to its production processes or services.
Only after the cost of goods manufactured is calculated can a company compute its cost of goods sold.
The Finished Goods Inventory is the difference between the beginning raw materials inventory and the ending finished goods inventory. In other words, you subtract the beginning raw materials inventory from the finished goods inventory.
Unlike the COGM formula, the COGS formula is:
Starting Inventory + Purchases – Ending Inventory = Cost of Goods Sold.
Importance of Cost of Goods Manufactured
The (COGS) is an essential component that provides a clear picture to business owners and managers about the company’s manufacturing performance.
The importance of the costs of goods manufactured include:
- Businesses track and record their expenses of goods manufactured to compare their previous operations with the present ones, spot patterns, and adopt solutions. They can use affordable small business accounting software to track and record the COGM.
- Since COGM only accounts for finished products the company has for sale or has sold, it is an excellent KPI for gauging a company's profitability.
- Knowledge of the cost of manufactured goods helps a company carry out better inventory management, keep better financial records, write accurate financial statements, calculate their ending raw materials and set effective financial goals.
Best Ways to Lower Cost of Goods Manufactured (COGM) without Compromising Finished Goods Inventory Quality
Increasing the prices of products you sell, as many companies do to increase their profit margin, can be counterproductive, especially when you are in a competitive target market and your competitors’ prices are lower.
The best way to increase your profit margin is to reduce your total manufacturing cost without compromising the product quality.
Here are some of the best ways to achieve this.
1. Reduce Labor Costs
Reducing labor costs is an excellent way to lower the expense of goods manufactured without compromising product quality.
You can reduce workers’ wages and salaries and hourly rate or make them more efficient in their work, simultaneously boosting the credit side of the balance sheet. With a proper monitoring system like the time logs or a system designed to calculate goods completed or a good manufactured, you can know those employees that are slacking and make proper adjustments.
2. Reduce Manufacturing Costs
Companies can easily reduce the cost of goods manufactured by reducing the materials required to produce its product.
You can reduce the expense of raw materials by buying them at a lower price. This general idea has the potential to cut costs beyond a specified period. The quality of raw material is too low relative to the initial quality, which will affect the production process. The solution is to buy in bulk. Suppliers always put discounts on bulk purchases.
3. Use Fewer Materials
You can reduce the number of raw materials you use in manufacturing your products without reducing or compromising their quality. Materials such as packaging and documentation costs should be at the barest minimum.
4. Consider Lean Manufacturing
The concept of lean manufacturing is all about reducing waste to an absolute minimum. According to lean manufacturing principles, there are seven types of waste that a company should address to be efficient. This vital information, if properly implemented, will help the company improve the production of goods manufactured.
- Overproduction is when you produce more than what you can sell in the market, causing wastage or forcing you to sell the remnant at a lower price.
- Conveyance refers to the unnecessary transportation of materials that can lead to waste or incur unnecessary transportation costs.
- Motion refers to all the unnecessary or awkward movement of workers and processes which is unproductive.
- Inventory is when you produce above what the market demands, which results in you spending more resources on storage especially when the excess product spends a long time in the storage facility.
- Waiting refers to delays and idle time expended in the process by the workers and your capital.
- Over-processing is when the company lacks a clear picture of its manufacturing processes or what its target audience needs.
- Defects refer to when a product requires changes either as finished goods or in the manufacturing stage that leads to more costs.
5. Reduce Manufacturing Overhead Costs (MOC)
Overhead costs are one of the easiest targets to eliminate from the books by companies when seeking to reduce the cost of goods manufactured. Reducing office supplies, building costs, insurance cover, etc., will help reduce expenses.