What’s it: Cost of goods manufactured refers to the collection of production cost plus the change in work-in-process inventory. These production costs (or manufacturing costs) consist of direct material costs, direct labor, and factory overhead costs. If there is no work-in-process inventory, then the cost of goods manufactured will be equivalent to the production cost.
Why the cost of goods manufactured matters
Calculating the cost of goods manufactured is useful for controlling operations and making some operating decisions. Specifically, management usually uses it to:
First, setting the selling price of the product. Under the cost-based pricing method, information on the cost of goods manufactured per unit is important for determining a product’s selling price.
In a simple calculation, the selling price equals the cost of goods manufactured per unit plus the profit margin (markup). Say, the cost of goods manufactured per unit is $100. The company sets a profit margin of 10%. In this case, the selling price equals $110 = $100 x (1 + 10%).
Second, monitoring the realization of production costs. Management will usually compare the actual vs. planned production costs, whether they are on target or not. If not, management then looks into the source of the problem and takes corrective action.
Third, calculating periodic profit. In calculating profit, management requires not only revenue data but also production costs. Assuming revenue does not change, the firm can increase profit by streamlining production, resulting in lower costs.
Fourth, Determining the cost of goods sold. At the end of the period, the finished product’s costs are presented in the finished product inventory. You can see this on the income statement. Meanwhile, the costs attached to the work in process are presented in the balance sheet.
Cost of goods manufactured components
Production cost comprises three main components, namely:
- Direct material costs
- Direct labor costs
- Overhead costs
Direct material costs include all costs associated with all materials identified as part of the finished product. It includes raw materials or semi-finished materials.
Direct labor costs include salaries and wages for workers involved in the production process. They contribute directly to making the product. They may be machine operators or workers at assembly stations.
Overhead costs consist of costs for supporting materials, indirect labor wages, and other indirect production costs. An example is a cost of renting a production machine.
Calculating the cost of goods manufactured
You can calculate the cost of goods manufactured using the following formula:
Cost of goods manufactured = Total manufacturing costs + Beginning work-in-process inventory – Ending work-in-process inventory
Total manufacturing costs (or production costs) include direct material costs, direct labor costs, and factory overhead. Meanwhile, the beginning work-in-process inventory represents the value of products in the production process. It has not been completed at the end of the accounting period. Therefore, the company does not count it as an inventory of raw materials or an end product inventory. Ending work-in-process inventory represents the cost of the partially completed work at the end of the accounting period.
Total manufacturing costs = Direct material costs + Direct labor costs + Factory overhead
To calculate the cost of direct materials used in the production process, you subtract the beginning inventory of direct materials from the ending inventory of direct materials.
Direct material costs = Purchase of materials + Beginning inventory of direct materials – Ending inventory of direct materials
Let’s take a simple example to apply the above formula. Say, a furniture manufacturer has $100 in stock of materials at the start of the period. At the end of the period, the inventory is $95.
During this period, the manufacturer spends $50 to purchase raw materials. Also, it spends $125 on employee salaries and $65 on rent and utilities. Meanwhile, work in process inventory at the beginning of the period is $10. Its value at the end of the period is $30.
From that case, let’s list the costs involved:
- Beginning inventory of direct materials: $100
- Ending inventory of direct materials: $95
- Direct material purchase: $50
- Direct labor: $25
- Factory overhead: $65
- Beginning work-in-process inventory: $10
- Ending work-in-process inventory: $30
Applying the above formula, we get:
- Direct material costs = $50 + $100 – $95 = $55
- Total manufacturing costs = $55 + $125 + $65 = $245
The cost of goods manufactured = $245 + $10 – $30 = $225
The cost of goods manufactured vs. the cost of goods sold
The cost of goods manufactured is different from the cost of goods sold (COGS). COGS takes into account finished goods, which may include obsolete unsold products. Meanwhile, the cost of goods manufactured only takes into account recently produced goods. During zero production, the cost of goods manufactured is zero. COGS may not equal zero if sales are less than the starting inventory.
To calculate COGS, you can use the formula below:
COGS = Beginning inventory of finished goods + Cost of goods manufactured – Ending inventory of finished goods
The formula above shows you the cost of goods manufactured is a component in the COGS calculation. The company then presents COGS in the income statement. Meanwhile, the cost of goods manufactured appears in the current assets section of the balance sheet.
Let’s take an example to apply the formula above. A company reports the following expenses:
- Direct materials: $4,000
- Direct labor: $200
- Factory overhead: $1,000
- Beginning work-in-process inventory: $60
- Ending work-in-process inventory: $70
- Beginning inventory of finished goods: $600
- Ending inventory of finished goods: $800
From those data, we can calculate:
- The cost of goods manufactured = $4,000 + $200 + $1,000 + $60 – $70 = $5,190.
- The cost of goods sold = $5,190 + $600 – $800 = $4,990