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.

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