how to effectively_predict_cost_of_goods_sold
Post on 13-Jan-2017
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How to Effectively
Predict Cost of Goods
Sold
You have heard of the TERMINOLOGY COST OF GOODS SOLD. But
what exactly is it?
Product based business
Service business
Cost of goods sold is th
e inventory you
have sold to your customers. Before
inventory is sold, the cost si
ts on the
balance sheet as "merchandise inventory"
and when sold, it moves to the profit and
loss statement as "cost of goods so
ld"
Your cost of services is what it c
ost you to
directly service your customers. Since
services are usually consumed as they are
provided, there is no inventory in most tr
ue
service businesses
Here is HOW IT WORKS
When a merchandise business buys
products for resale it is an inventory asset
When a merchandise business sells the
product, it becomes cost of goods sold
Effectively predicting cost of goods sold
A rise in cost of goods sold cause’s margins to diminish. Rightly
predicting cost of goods sold starts with accurately predicting sales
Inventory/ cost of goods sold cost is split into 3 partsThere are 3 components to inventory cost
Direct materials
Direct Labor
Manufacturing overhead
Direct MaterialThe price of your materials are based on 2 main factors
The cost of producing your
materials
The quantity you buy
Factors affecting priceThe following factors affect the cost of your materials
Industry value chain cost * Markup
Markup for scarcity (if no substitutes
available) or Markdown for
surpluses
Markup for inflation
Industry Value Chain Cost
Consists of the resource owners cost * Markup&
Markup for the number of businesses in the industry value chain before the material gets to you
Industry Value Chain
Resource owner's cost * Resource owner's markup * Markup for number of touch points in your industry value chain
Each business that handles the material adds their own markup
Resource owners cost and conversion agents costs totals your industry value chain cost
Markup for scarcity or Markdown for surpluses
Some downsides of being in an industry when you have low bargaining power are
Cost of goods sold will be higher
Shortage of supplies
When this is the case the cost of your goods will be higher. In estimating your material cost, include a markup
Consideration for availability of substitutes
When cheaper substitutes exist that could meet the same purpose, the
cost of buying the materials you need may be less
Markup for inflation
Industry value chain cost * Markup for scarcity or Markdown for surpluses * Markup for inflation
Taking inflation into consideration, the price of the goods we sell can be calculated as follows
Direct Materials: What determines how much material we buy?
Quantity = Sales forecast (subject to market supply & business capacity) + quantity at which economies of scale occur
The equation for quantity purchased is as follows
Direct material summary
Direct Material Cost = Quantity * Price
Quantity = Sales forecast (subject to market supply & business capacity) + quantity at which economies of scale occur
Price = Industry value chain cost * markup for scarcity or markdown for surplus* markup for inflation
Direct Material Cost = (Sales forecast (subject to market supply & business capacity) + quantity at which economies of scale occur) * (Industry value chain cost * markup for scarcity or markdown for surplus* markup for inflation)
Direct Labor
Direct Labor = Number of hours needed * Price per hour
The cost of direct labor can be calculated as follows
Number of hours needed for direct labor
Direct labor hours = Number of hours needed to bring sales forecast to reality * percentage
discount for skilled labor set
The more experienced your labor force, the less hours you should need to get the same output
Price per hour
Price per hour = Average market price * premium for skill sets with limited supply
Moving your business to a location with a wide pull of candidates will drastically lower your total labor
cost
Direct labor summary
Direct Labor = Number of hours needed * Price per hour
Direct labor hours = Number of hours needed to bring sales forecast to reality * percentage discount for skilled labor set
Price per hour = Average market price * premium for skill sets with limited supply
Direct labor = (Number of hours needed to bring sales forecast to reality * percentage discount for skilled labor set) * (Average market price * premium for skill sets with limited supply)
Overhead
Overhead cost =Activity level * buffer percentage * cost per unit
Your overhead should allow for the uncertainties in the market place. You do this by including a buffer in the activity level as
follows
ConclusionAs inventory is the number one line item that eats cash, it is essential to minimize cost. Knowing the factor that influence the prices you pay, can
help you make smarter choices
Direct materials
Direct Labor
Overhead
Each of these components have many factors that affect their estimation while developing
your budget. The whole point of going through the equations discussed is not to achieve
perfection but to help you think beyond your normal
Read full article: www.mybusinesskpi.com/CostOfGoodsSold.html
Predictive Accounting with KPIs: A More Predictable, Less Stressful Way to Run Your Business.
Phone: (417) 812-5945
Address: 1700 S Spring Street, Springfield, IL 62703
Email: evelyn@mybusinessskpicoach.com www.mybusinesskpi.com
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