Why is it that Accounts Payable is projected by DPO, which factors in COGS? What is the correlation between A/P and COGS here?
Similar with inventory, you use DIH (Days Inventory Held) which is Inventory/COGS x 365. Why would the denominator be COGS and not Sales. I just don't understand the intuition with these two, but the other B/S items are pretty straight forward for the most part.
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You have to think through what A/P means, and how the accounting lines up. Below is an attempt to map it out. Let me know if this doesn't make sense.
Let's assume that all transactions are done with credit, and no cash changes hand.
You take in raw materials to make your finished goods. These goods cost $10, so you now have A/P of $10.
You have a liability of $10 A/P, and this gives you an asset, inventory worth $10.
You proceed to sell this inventory for $20. Now you have A/R of $20, inventory of $0, and sales of $20, and COGS of $100.
NOTE: Your COGS matches the accounting value of the inventory, before it was sold, and your A/P (up until you pay it).
You buy more inventory
Your A/R are paid for.
After a given period of time, you pay off your A/P.
So you keep doing these 4 steps, 10 more times over the course of the year, and then balance sheet is drawn up after you've bought your inventory but before you've paid off all your A/P again, or received cash for your A/R (in a more realistic scenario, you wouldn't actually pay off your A/P completely, of course; this would all be a fluid situation).
Now, for the period you have:
Sales: $200 ($20 * 10) COGS: $100 ($10 * 10) A/P: $10 A/R: $20 Inventory: $10
Note that you've "gone through" your inventory 10 times, and 10 times you have turned over your accounts payable. This means you go through your inventory roughly once every 36.5 days.
If you use sales as your denominator for DIH, you get ($10/200 * 365) = 18.25. As you can see, this is wrong! The reason is,
sales has nothing to do with the value of your inventory. The same holds true for A/P
If you use COGS, which is based on the accounting value of your inventory, you get ($10/100 * 365) = 36.5.
Much better!
Thanks, this helped a lot. Makes perfect sense
Sir did you by any chance had a mistake in your first COGS (shouldn't they be $10 rather than $100?)
When you buy supplies/raw material from vendor, you owe them money (A/P). You need to pay for these supplies' price which is recorded as COGS in your book.
The same is with inventory. It is related to the COGS.
COGS is just more directly correlated to Inv and AP.
Think on the buyer side, Sales price = COGS + premium that you want to make to cover other expenses and profit (assuming you are not selling at discount). You want to determine the days of inventory and AP from your COGS purchase. The "premium above COGS" to get to sales can fluctuate depending how much you want to sell for but COGS is always the same
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