How to Find COGS Variable and Fixed Cost?

Barbell Capital's picture
Rank: King Kong | 1,067

I am very frustrated. I am taking one summer class on Financial Management and our professor is making us do a 2-statement forecast (apparently, basic cash flow projection is too hard, so balance sheet is not balanced at all, lol).

I was taught by WallStreetPrep and few banking models that COGS is 100% variable cost. If Revenue goes up by 10%, COGS goes up by 10% or somewhat similar.

My professor says I am wrong. He said COGS includes things like CEO's salaries and others that are constant (aren't they in SG&A?). He said COGS has a variable part, that is a certain percentage of revenue (for example, 60% of revenue is variable part of COGS). COGS also has a fixed part: a percentage of previous year's COGS.

What is Variable and Fixed Cost of Goods Sold?

While the vast majority of COGS expenses are variable costs, in some cases (especially for companies that are manufacturers) there is a fixed cost associated with the production of goods such as the utilities at the manufacturing plant. The cost of keeping the lights on and running AC, will be the same whether you manufacture 100 gadgets or 10,000 gadgets (unless overtime is factored in). It is important note that there is a difference between the cost of lighting your office building where management works (which would fall under SG&A expenses) and the cost of lighting your plant where you produce the goods (which would fall under COGS).

Therefore, variable costs will represent the majority of cost of goods sold and there will be a small portion of fixed costs. However, when modeling - due to the small portion that this will make up, it is safe to model as if COGS is a variable percentage.

COGS Formula

At a simple level, the cost of goods sold is the beginning inventory for a period + the purchase or manufacturing of goods - the ending total of goods. This will be the COGS sold and represents the cost to purchase or create the goods that you sold during the period. You can see a video about this below.

Read More About COGS on WSO

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Comments (19)

Aug 13, 2009

Let me take a shot. I am still new at this, so I may not be 100% right.

COGS does not include the CEO's salary (that is SG&A). It does, however, include some labor costs such as the worker who produces the good.

COGS = Variable COGS + Fixed COGS. There are fixed COGS such as repairs to M&E. They should be small compared to the variable COGS.

Also, if revenue goes up by 10%, it does not necessarily mean that COGS goes up 10%. This is because higher revenue could be due to higher prices, which does not affect the cost of making the goods. Similarly, revenue could be from licensing/royalty fees, which again do not cause a proportional increase in COGS.

Hope that helps, anyone who disagrees feel free to correct me.

Aug 13, 2009

Though I am not an expert on accounting, I assume COGS to be variable.

First of all, "cost of goods sold" indicates already that the costs are directly related to output. Although, as already mentioned, COGS do no necessarily have to increase with sales.

COGS includes all kinds of costs that can be directly allocated to a product or service, e.g. labor costs, utility costs for certain production processes, material etc. Fixed costs which are not direclty allocated are mostly depreciated (like plants) or impaired (like goodwill).

So I may be wrong on this point and open to correction, but this would be my first thought on the issue.

I have never come across the formula, but one reason your profs says there is a fixed variable in COGS might be some time delay. For instance, although labor costs are clearly variable, they are obviously fixed in the short run. This may be one reasons why your prof includes previous year's cogs in his formula. (obviously I am only guessing here)

Aug 13, 2009

how is impairment of goodwill a fixed charge? Doesn't mngemnt test goodwill annually for impairment and obviously its not a systematically depreciated item?

KICKIN ASS AND TAKING NAMES

Aug 13, 2009
BudFox24:

how is impairment of goodwill a fixed charge? Doesn't mngemnt test goodwill annually for impairment and obviously its not a systematically depreciated item?

Yeah, your are right, it is tested annually and not depreciated systematically. (it used to be some years ago). So bad example from my part. Sorry for that.

Aug 13, 2009

no worrys man i wasn't sure if i was right either. Hopefully someone with experience can elaborate.

KICKIN ASS AND TAKING NAMES

Aug 13, 2009

Ask your community college professor if the CEO's salary would be foregone if the company didn't have any sales activity.

Also ask him what an administrative cost is in SG&A.

Aug 13, 2009

Generally speaking, COGS will always have a fixed and variable component. For example, manufacturing businesses generally include direct costs (e.g. materials and direct labor) and an allocation for overhead (e.g. utilities, supervisor salaries, maintenance, operating lease payments on equipment, etc.) in the COGS line item. Using percentages to forecast materials provides a good proxy, but supervisor salaries, operating lease payments and utilities are fixed and should be forecast accordingly.

Hope this helps.

Aug 13, 2009
jdm05520:

Generally speaking, COGS will always have a fixed and variable component. For example, manufacturing businesses generally include direct costs (e.g. materials and direct labor) and an allocation for overhead (e.g. utilities, supervisor salaries, maintenance, operating lease payments on equipment, etc.) in the COGS line item. Using percentages to forecast materials provides a good proxy, but supervisor salaries, operating lease payments and utilities are fixed and should be forecast accordingly.

Hope this helps.

If you're talking about a factory, then the factory labor, foreman, electricity, etc... should be allocated down to COGS... but your executive offices, marketing, etc... are definitively SG&A.

Aug 13, 2009

I agree that executive offices, marketing, etc. should be allocated to SG&A. The point is that COGS has fixed and variable components.

Aug 13, 2009

What an absolutely ridiculous way to project COGS. Do yourself a favor, make an estimate on gross margin based on intelligent insight or some equity research. His method of calculating COGS is incredibly stupid. Arbitrarily picking %A and %B can end up yielding you incoherent operating results. Tell him he is an idiot and by him a book by damodoran.

Aug 13, 2009

It all depends on the company. We're evaluating a company right now that claims they have very few variable COGs. After diligencing their numbers, it turns out quite a few of the COGs were fixed and a number of the SG&A expenses were variable.

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CompBanker

Aug 13, 2009
CompBanker:

It all depends on the company. We're evaluating a company right now that claims they have very few variable COGs. After diligencing their numbers, it turns out quite a few of the COGs were fixed and a number of the SG&A expenses were variable.

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CompBanker

Is this a trend that is more prevalent in certain industries/companies? And how does this impact valuation? Would I be correct in assuming it's not preferable?

Aug 14, 2009

I think the main point is that if you're building a full operating model/P&L, then you're obviously hitting each expense line item one by one, in which case the fixed/step/variable costs are accounted for accurately.

Anything short of that, the most straightforward way to go about it is to just use COGS as a % of sales.

Aug 14, 2009

It's sort of makes sense to have fixed/variable, but an analyst have to know the industry pretty fucking well. Professor makes us do that fixed/variable crap, yet no cah flow projections, because they are "too hard".

Aug 14, 2009

The Sales Method of projecting future financial statements is based on the assumption that Sales is the main driver. I am sure if you run a regression or crystal ball analysis like one of professors used to obsess about you will see there is fixed portion for some companies in COGS.

I bet your professor comes from a Credit Risk or Management Accounting background.

Aug 14, 2009

Yeah, you're correct. Not sure if specific industries do it differently but COGS would be a component of opex. Again, depending on industry, many of the other things you mentioned may actually be capitalized though and not fall under opex.

Aug 14, 2009

Some companies will include COGS right below revenue and have a "gross profit" line below that. Others will include COGS as part of OPEX, such as rent. It depends on the company, but when laying out financial statement in Excel, I like to move COGS below revenue to give everyone a clearer picture of gross profit margin.

Aug 14, 2009
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