This chapter explains how Cost of Goods Sold (COGS) is derived and how to achieve realistic COGS values.
What is COGS?
COGS is the inventory cost of items sold captured at time of order picking. Each item’s inventory cost is derived from job receipt costs averaged into the value of any stock on hand. Job receipt costs reflect the following job input costs:
•Material costs from job issues
•Absorbed labor costs from job labor hours
•Absorbed manufacturing overhead costs from job labor hours
•Subcontract service costs from PO receipts to job sequences
Inventory costing meets GAAP standards and IRS requirements
Inventory costing in DBA meets GAAP standards and IRS requirements in which direct labor and manufacturing overhead costs must be absorbed into inventory value and only realized as cost of sales expenses when items are sold.
COGS is not actual job cost
COGS is an inventory cost that often differs from actual job cost. The inventory cost is an average cost where the cost of each job receipt gets averaged into the cost of any stock on hand. Job receipt costs also can differ from actual job cost such as when the estimated job cost is used for partial receipts or as the default job cost basis.
Job receipt costs are approximate costs
The job receipt costs that update average inventory cost are always approximate costs because true actual costing is not possible. For example, actual supplier invoice costs for material and subcontract services are not fully knowable when POs are received, so the PO cost is used instead , even though it may differ later from actual invoice cost. Absorbed labor and absorbed manufacturing overhead costs are based on hourly rates that can never exactly match actual costs.
Inventory costs are self-correcting through actual cost variances
The approximate costs that constitute inventory value and flow through to COGS are self-correcting through the following actual cost variances.
Indirect Cost Accounts
The following adjustment accounts are located in the Indirect Costs account class within the Cost of Sales section of the income statement. These accounts adjust inventory value to reflect variances between actual costs and prior transaction costs.
During PO invoice matching, any variance between the PO receipt cost and supplier price gets posted to RNI Adjustments and washes out the over or under-absorption of material cost into inventory.
When a job gets closed, any variance between total job input costs and total job receipt costs gets posted to WIP Adjustments and washes out the under or over-absorption of costs into inventory.
Inventory Adjustments or Adjustments COGS
When a change in quantity is made through a stock count or stock adjustment or an inventory cost change is made, the change in inventory value is posted to Inventory Adjustments and washes out the previously incorrect inventory value.
Absorbed Cost Accounts
The following accounts are located in the Absorbed Costs account class within the Cost of Sales section of the income statement. Cost of sales is automatically adjusted by the variance between absorbed an actual costs.
Absorbed Labor vs. Actual Labor Costs
All job labor transactions credit Absorbed Labor, which offsets debits to direct labor payroll and associated expense accounts. This credit offset is the means by which actual labor costs are absorbed into work in process. Any variance between absorbed and actual labor costs washes out any over or under-absorption of labor costs into work in process.
Absorbed Mfg Overhead vs. Actual Mfg Overhead Costs
All job labor transactions also credit Absorbed Mfg Overhead, which offsets debits to manufacturing overhead expense accounts. This credit offset is the means by which actual overhead costs are absorbed into work in process. Any variance between absorbed and actual overhead costs washes out any over or under-absorption of overhead costs into work in process.
Total cost of sales is a blend of COGS and actual cost variances
COGS in isolation does not represent your cost of sales. Total cost of sales is a blend of COGS and the actual cost variances listed above. When actual cost variances are within normally expected ranges, COGS is a realistic indicator of the inventory contribution to cost of sales. To the degree that actual cost variances exceed normally expected ranges, COGS becomes less realistic and less meaningful. .
Realistic COGS is achieved with realistic transaction costs
COGS can only be as realistic as item inventory costs, which are derived from manufacturing transaction costs. If you apply realistic costs to all your transactions, you will achieve realistic inventory costs. If your transaction costs are inadequate, non-valid, or error-prone, inventory costs will not be realistic or meaningful.
COGS cannot be adjusted after the fact
COGS derives from each item’s inventory cost and cannot be adjusted after the fact when anomalies are detected after jobs are closed. Inventory cost is affected by numerous interdependent transactions, including customer payments, invoices, shipments, order picking, job receipts, job labor, job issues, supplier payments, PO invoices, and PO receipts. Many such transactions will be in closed accounting periods. There is no practical or safe way to reverse, adjust, and repost such a complex web of interconnected transactions.
Actual cost variances account for costing errors
Costing errors, such as double entry of labor, have no impact on net income because any such errors that get incorporated into inventory value are offset by actual cost variances. So even though errors are not desirable and should be minimized as best you can, they do not affect the integrity of the income statement.
Achieving Realistic COGS
To achieve realistic and meaningful COGS on the income statement, you must apply realistic costs to your manufacturing transactions. You can accomplish this by taking the following measures:
1. Make sure all PO lines have a realistic supplier price
Make sure all PO lines are sent out with a realistic supplier price. We recommend that you maintain a Supplier Price against each item, which flows through to MRP, and update this price during PO Invoice matching whenever it changes. Never send out POs with a zero price unless there is a deliberate reason for doing so.
2. Update P item estimated costs on a regular basis
Use the Estimated Purchase Costs screen to mass update P item estimated costs on a regular basis, such as weekly or monthly.
3. Maintain realistic cycle times
Maintain realistic cycle times in your BOM routings. Never enter a routing sequence without a cycle time unless there is a deliberate reason for not doing so.
4. Maintain accurate bills of material
Material costing is dependent on accurate bills of material. Whenever actual job usage quantities differ from specified job quantities, be sure to correct component specifications in the BOM for accurate cost rollups and to provide future jobs with accurate specifications.
5. Update shop rates on a periodic basis
Use the Shop Rates screen to update hourly shop rates for labor and manufacturing overhead on a periodic basis, such as once a quarter.
6. Run the cost rollup on a regular basis
Use the Cost Rollup screen to roll up estimated costs for manufactured items on a regular basis, such as once a week.
7. Enter job transactions in real time
Enter job issues, job labor, job subcontracting, and job receipt transactions in real time as activities occur. Facilitate this by providing computer devices throughout the shop. Real time entry reduces errors and insures that all job costs are accounted for at time of job receipt.
8. Receive finished items at a realistic cost
If you take all the previous measures, the Suggested Cost calculated in the Job Receipts screen will provide a reliable and realistic cost suitable for updating inventory. Even so, whenever the Suggested Cost is obviously incorrect because input costs are not all accounted for or a significant input costing error has occurred, make appropriate corrections and then receive at a realistic cost.
NOET: A good way to insure realistic receipt costs is to use the Estimated job Cost basis (selected in Jobs – Jobs Setup – Job Cost Basis) in which case all receipts are made at estimated job cost instead of a calculated actual cost.
9. Never reopen jobs to make cost adjustments
Never reopen jobs to make cost adjustments. One of the purposes of job closing is to examine costs and make timely corrections before the finished item gets issued to other jobs or picked for shipment. If a costing error gets discovered after job close, leave it be because the resultant higher or lower inventory cost that flows through to COGS washes out with actual cost variances.
10. Make sure your chart of accounts is structured properly
It is essential that the Indirect Costs accounts and Absorbed Costs accounts listed at the beginning of this chapter are located in your Cost of Sales section. In particular, locate your actual direct labor accounts following your Absorbed Labor account and locate your actual manufacturing overhead accounts following your Absorbed Mfg Overhead account. Refer to the chart of accounts in the sample company for guidance.
Transitioning from a Non-Valid System to a Valid System
Even though your COGS and offsetting actual cost variances is always 100% correct in an accounting sense, you may discover at some point that you have been operating with a non-valid costing system.
What is a non-valid costing system?
A non-valid costing system is one where your inventory and COGS has no meaningful value. This can be caused by a variety of bad practices, such as sending out POs with zero prices, not updating P item estimated costs, not using routing cycle times, not updating shop rates for labor and overhead, and not running cost rollups. Consequently, your inventory value and COGS may have no meaningful values, perhaps over a long period of time.
Past periods cannot be adjusted
Because all manufacturing costs are transaction based, there is no practical way to go back into previous periods to reverse and adjust potentially thousands of transactions, including paid invoices. Therefore, your inventory value and COGS for past periods must remain as is.
NOTE: Keep in mind that even though your transaction costs have been non-valid, they do wash out with actual cost variances over time and have no long term effect on income. If you have been properly entering actual direct labor and manufacturing overhead costs through payroll and supplier bills, your total cost of sales over time will be correct.
Transaction costs can be realistic from this point forward
If you implement the measures listed in the Achieving Realistic COGS section above, transaction costs from this point forward can be realistic. Over a period of time the existing non-valid work in process and inventory values will work themselves out of the system.
You can change inventory costs for stock on hand
After you implement the measures in the Achieving Realistic COGS section and you have realistic rolled up costs for manufactured items, you can use the Change Inventory Cost screen to change the inventory cost of items with stock on hand to their estimated costs. Those items will then have realistic costs from this point forward that will be applied to job issue and order picking transactions.
NOTE: Inventory cost changes can significantly affect current income. For example, if you experience a major increase in Inventory value by replacing incomplete item costs with complete costs, the offsetting credit balance in Inventory Adjustments will abruptly increase current income. Conversely, if Inventory value decreases, you will experience an abrupt income reduction or loss.
Will a labor costing error affect my income?
A job costing error does not affect your income because if the error gets reflected in the job receipt cost, the resultant higher or lower inventory cost that flows through to COGS washes out with actual cost variances.
Let’s say job labor was accidentally entered twice. Instead of $100 labor cost, the job was charged with a $200 labor cost. The following postings demonstrate that this $100 cost overrun has no effect on net Cost of Sales.
Initial Costing Error Occurs with Job Labor Entry
$100 Debit Work in Process
$100 Credit Absorbed labor
Error Flows through Job Receipt to Inventory
$100 Debit Inventory
$100 Credit Work in Process
Error flows to COGS through Invoicing
$100 Debit COGS
$100 Credit Inventory
Cost of Sales transactions are highlighted in blue. Note that the credit and debit amounts wash out so that there is no effect on net income.
Does direct labor payroll cost flow through to COGS?
Direct labor payroll costs do not directly flow through to COGS. Actual payroll costs are used to establish an hourly shop labor rate in the Shop Rates screen. The shop labor rate is the basis for the work center hourly rates that are used for job labor costing.
What is the significance of WIP Adjustments?
When a job is closed, any difference between total job input costs and total job receipt costs is posted to WIP Adjustments in order to keep the Work in Process account in balance. It is normal and expected for job variances to occur, especially when the Estimated Job Cost basis is selected in the Job Cost Basis screen, in which case a job close variance is expected with each job.
Over time the debits and credits to this account should be in rough balance because some jobs will close with a positive variance and some with a negative variance.
What does a large debit balance in Inventory Adjustments mean?
An unusually large debit balance in Inventory Adjustments can indicate the following anomalies:
•Stock counts are consistently detecting less stock on hand than expected, which can indicate inaccurate BOM component usage quantities, not returning unused job material to stock, or shrinkage due to theft or other factors.
•You are using stock adjustments to issue or receive items instead of making transactions through the Job Issues and Job Receipts screens. Using stock adjustments in this manner is destructive to the costing system and must be immediately stopped.
What does a large credit balance in RNI Adjustments mean?
An unusually large credit balance in RNI Adjustments indicates that you are issuing POs without supplier prices or with outdated supplier prices. This is harmful because your job material costs are understated, which ultimately results in understated and unrealistic COGS. The solution is to always send out POs with realistic supplier prices.