Costing is the business function of collating and apportioning expenditures so as to determine costs of products, processes or functions. Costing has several purposes including inventory valuation, determination of selling prices, cost control as well as assisting management in decision making. Two important costs which are derived as a result of costing function are cost of goods manufactured (COGM) and cost of goods sold (COGS). These costs assume importance in determining gross profitability of an entity.
The article “cost of goods manufactured vs cost of goods sold” looks at meaning of and differences between these two types of derived costs.
Definitions and meanings
Cost of goods manufactured (COGM)
Cost of goods manufactured (COGM) is the sum total of manufacturing costs incurred on finished goods that have been produced within a specific accounting period. It consists of only those costs which are incurred during the production process and that are necessary to produce finished goods. Thus, all other costs which are not directly related to production process such as office costs, marketing, selling and distribution costs etc. do not form part of the cost of good manufactured.
The formula for calculating COGM is:
| Value of opening work in progress | XXX |
| Add: cost of direct materials | XXX |
| Add: direct wages | XXX |
| Add: cost of production overheads | XXX |
| Less: closing stock of work in progress | (XXX) |
| Cost of goods manufactured | XXX |
For the purpose of the above formula, the costs considered are all those costs which are incurred in the manufacturing process only. These typically include the following:
- Direct material cost such as raw materials, packing materials etc.
- Direct wages such as salary of factory workers, shop floor supervisors, quality check workers who are dedicated to the production process.
- Allocated production overheads such as power, factory rent and machinery depreciation etc.
Work in progress inventory represents those goods which are still in production at the close of a fiscal period. The rationale behind making adjustments for opening and closing inventories of work in progress is so that the cost calculated represents only the goods actually produced within the specific period.
Numerical example
M/s ABC manufactures pencils. Following is its accounting information for the accounting year 2019:
Costs incurred:
| Particulars | Amount (USD) |
| Raw materials purchased | 20,000 |
| Wages of factory workers | 10,000 |
| Office staff salary | 4,000 |
| Production overheads | 4,000 |
| Distribution costs | 2000 |
| Office administration costs | 3000 |
| Marketing costs | 2000 |
Inventory information:
| Particulars | Value (USD) |
| Opening stock of raw material | 5,000 |
| Closing stock of raw material | 6,000 |
| Opening stock of WIP | 10,000 |
| Closing stock of WIP | 8,000 |
| Opening stock of finished goods | 15,000 |
| Closing stock of finished goods | 13,000 |
In the above example, cost of goods manufactured would be:
| Value of opening work in progress | 10,000 |
| Add: cost of direct materials used (5,000+20,000-6000)* | 19,000 |
| Add: direct wages | 10,000 |
| Add: cost of production overheads | 4,000 |
| Less: closing stock of work in progress | (8,000) |
| Cost of goods manufactured** | 35,000 |
* Considering adjustments of opening and closing stock of raw materials.
**Expenses such as office and other expenses not related to production process have not been considered.
Cost of goods sold (COGS)
Cost of goods sold (COGS) is the sum total of manufacturing costs incurred to produce those finished goods that have been sold by the entity during the specific accounting year. Similar to cost of goods manufactured, cost of goods sold also considers only production related costs.
The formula for calculating cost of goods sold is derived from the cost of goods manufactured and is as follows–
| Value of opening stock of finished goods | XXX |
| Add: cost of goods manufactured/purchased | XXX |
| Less: closing stock of finished goods | (XXX) |
| Cost of goods sold | XXX |
The rationale behind making adjustments for inventory holdings of finished goods is to derive the cost related to only the quantity of goods that have actually been sold during the accounting period.
Continuing the above example of M/s ABC, the cost of goods sold would be:
| Value of opening stock of finished goods | 15,000 |
| Add: cost of goods manufactured | 35,000 |
| Less: closing stock of finished goods | (13,000) |
| Cost of goods sold | 37,000 |
The cost of goods sold is deducted from sales revenue to arrive at gross profit. Hence ascertaining cost of goods sold helps an entity to assess its gross margins.
Difference between cost of goods manufactured and cost of goods sold
The key points of difference between costs of goods manufactured and cost of goods sold have been detailed below:
1. Meaning
- Cost of goods manufactured are the production costs incurred on finished goods produced in a specific accounting period.
- Cost of goods sold are the production costs incurred on goods actually sold in a specific accounting period.
2. Valuation of
- Cost of goods manufactured as the name suggests is concerned with valuation of goods produced.
- Cost of the goods sold on the other hand is concerned with valuation of goods actually sold.
3. Hierarchy
- As production takes place before sales can take place, cost of goods manufactured is calculated first.
- Cost of goods sold is subsequently calculated and derived from and after calculation of cost of goods manufactured.
4. Consideration of inventory holdings
- The formula for cost of goods manufactured makes adjustments for opening and closing stock of raw materials and work in progress only.
- The formula for cost of goods sold makes adjustments for opening and closing inventories of all types of inventory i.e., raw materials, work in progress and finished goods
5. Impact of sales
- The quantum of sales booked by an entity has no impact on calculation of cost of goods manufactured. Hence this cost would be incurred even if there are no sales.
- Cost of goods sold is impacted by and dependent on quantity of goods sold. This impact is reflected through adjustment of inventories of finished goods. Hence this cost would be nil in a case of no sales.
6. Calculation of profitability
- Calculation of cost of goods manufactured by itself will not result in calculation of profitability.
- Calculation of cost of goods sold after computing cost of goods manufactured results in ascertaining profitability, once deducted from sales revenue.
7. Disclosure in financial statements
- Cost of goods manufactured are generally not separately disclosed in the income statement of an entity. It is used as a basis for calculation for cost of goods sold.
- It is cost of goods sold that is disclosed in the income statement of the entity, which is then used to derive gross profit.
8. Relevant to type of entities
- Cost of goods manufactured is calculated only by manufacturing entities.
- Cost of goods sold although of primary importance to manufacturing entities can also be calculated by retail or trading entities that purchase goods for sale.
Conclusion – cost of goods manufactured vs cost of goods sold:
The primary importance of calculation of cost of goods manufactured and ultimately cost of goods sold is to determine gross profit margins of each product line as well of the entity as a whole. This helps management in evaluating the efficiency of the production process and also in determining the price point setting for each of its products based on its profit margins. The accurate calculation of both cost of goods manufactured and cost of goods sold however is dependent on the valuation of inventory. It is thus essential to ensure that inventory valuations are neither overinflated nor underinflated to ensure accurate determination of these costs.
