Understanding and Calculating Cost of Goods Manufactured

1. April 7, 2010 • Starting to Build the Income Statement • To build the Income Statement, we must know COGS • To know COGS for a manufacturing company, we must know Cost of Goods Manufactured • Build up and calculation of Cost of Goods Manufactured • Fixed versus Variable Costs • Other cost distinctions

2. Setting up the Income Statement • Revenues – • Relatively straight forward, from your Financial Accounting • Less Cost of Goods Sold (COGS)

3. Inventory Flows • Calculating inventory balances • Beginning inventory, plus • Additions to inventory, less • Withdrawals from inventory, equals • Ending balance • This straight forward formula holds true • For a simple merchandising situation where inventory is in a single account, • For each inventory account of a manufacturing company • Raw Materials, Work in Progress and Finished Goods

4. Inventory Flow - Example • Pick a merchandising company • It has $50 million of inventory on Jan 1, 2010 • It purchased $10 million on Jan 13, 2010 • By Jan 31, 2010, its sold $42 million of its finished goods stock • What was the company’s opening inventory on Feb 1, 2010?

5. Inventory Flow - Example • Pick a manufacturing company • It has $10 million of raw materials inventory on Feb 1, 2010 • It purchased $5 million of additional raw materials on Feb 2 • It started working on converting $7 million of raw materials during Feb • By Feb 28, 2010, its sold $15 million of its finished goods • What was the company’s opening raw materials inventory on Feb 1, 2010?

6. Calculating Cost of Goods Manufactured • A Merchandiser does not manufacture, so there is no Cost of Goods Manufactured • COGS are simply the costs of what inventory it purchased • (Note this is a bit simplified as some companies may add some processing costs) • For a manufacturer, in order to calculate COGS, we need to know the costs of what the company has produced that is available and for sale and sold • By definition, these must be Finished Goods only • Therefore, we must calculate the flows and balances through each inventory account

7. Schedule of Cost of Goods Manufactured As items are removed from raw materials inventory and placed into the production process, they are called direct materials.

8. Conversion costs are costs incurred to convert the direct material into a finished product. Schedule of Cost of Goods Manufactured As items are removed from raw materials inventory and placed into the production process, they arecalled direct materials.

9. Schedule of Cost of Goods Manufactured All manufacturing costs incurred during the period are added to the beginning balance of work in process.

10. Schedule of Cost of Goods Manufactured Costs associated with the goods that are completed during the period are transferred to finished goods inventory.

11. Cost of Goods Sold

12. Cost of Goods Manufactured – Example • At year end, a manufacturing company has the following inventory balances: • RM - $12m, WIP - $20m, FG - $10m • Assume the following: • $12m of RM materials are purchased • $10m of RM are drawn into production • DL of $10m, MOH of $3m in the period • WIP closing balance was $10m • FG closing balance was $12m • Prepare a schedule of Cost of Goods Manufactured and calculate COGS for the period • Assume revenues of $50m, S&A of $10m – Prepare an I/S

13. Cost of Goods Manufactured – Example • Which of these accounts are Balance Sheet Accounts? • Which are Income Statement Accounts?

14. Income Statement – Example • Is this a profitable company? • Would you invest in this company? • At what valuation?

15. Income Statement – Investment Decisions • Is this a profitable company? • Yes, of course • Look to the margin % • Is it profitable enough? • What industry is it in? • What are its competitors’ results? • Would you invest in this company? • What are the trends in the industry and with the company? • At what valuation? • What levels of returns would are reasonable to expect from taking on this level of risk?

16. Fixed and Variable Costs • Fixed Costs • Total Fixed Costs do not change with changes in activity • Variable Costs • Total Variable Costs change with changes in activity • Plot cost on the X axis, and activity on the Y axis for the following cost examples: • Factory lease • Direct labour • Machinery depreciation

17. Fixed and Variable Cost Classifications for Predicting Cost Behavior

18. Other Cost Classifications • Differential Costs and Differential Revenues • Used for decisions among alternatives • Sunk Costs • Opportunity Costs • These are in addition to: • Fixed versus Variable • Direct versus Indirect • Period versus Product • Of course any cost item can fit into a number of these categories

19. Purpose of Cost Classifications • We have seen there are many ways of classifying costs • Each type falls into one or more of the following purposes: • Financial Reporting • Inventory on Balance Sheet • COGS and S&A on Income Statement • Predicting Cost Behaviour • Fixed and variable costs • Assigning Costs to Objects • Product costs • Decision Making • Differential costs and revenues

20. Review • Starting to Build the Income Statement • Understand how inventories flow through the income statement • Build up and calculation of Cost of Goods Manufactured • Only for manufacturing companies • Fixed versus Variable Costs • Businesses can control variable costs in the shorter term • Other cost distinctions

21. Tutorial • Introduction to Group Project

22. You will be divided into groups Select a public company of your choice and submit financial statements Describe the company and explain why the company was selected; what kind of accounting systems might the company use? Write and present during tutorial – Monday, April 12th Together, we will simplify the accounts for modeling purposes – April 15th Make your own assumptions and forecast/budget (I/S, B/S, C/F) for three years Conduct ratio analysis and draw conclusions about the company Each group is to present final results – May 5th Each individual is to select a role (CEO, CFO, Sales, Production Manager, etc) and present 5 - 10 minutes of observations – May 5 Audience to prepare questions for presenters Submit and present final results – May 5th in lecture Group Project - 20%