Cost of Goods Manufactured (COGM)

Cost of goods manufactured (COGM) considers the costs of producing your product, including factors such as cost of direct materials, direct labor, and factory overhead.

Cost of goods manufactured (COGM) considers the costs of producing your product. It is calculated by adding the cost of direct materials, direct labor, and factory overhead.

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In the manufacturing industry, COGM indicates how much it costs to produce a unit or specific quantity of a particular good. Therefore, it is also known as the cost of production. 

A business would use COGM to determine if their products are profitable enough to continue production or if there are opportunities for changes within their operations that might reduce costs and increase profits. This article discusses the basics of COGM, including its importance and how it is calculated.

Typically, COGM is calculated for an individual product or batch of products. For example, if you are manufacturing t-shirts, you would calculate COGM by calculating all of the costs associated with making t-shirts - from buying fabrics to cutting t-shirts and sewing them together. Likewise, if you sell t-shirts on a website using dropshipping, you will calculate COGM for each unit of t-shirts sold.

COGM is important because it helps determine the net income a company can generate from its production process or changes required to make it profitable. It is also used for budgeting purposes and calculating the cost of goods sold (COGS).

What is the formula to calculate the COGM?

The cost of goods manufactured (COGM) measures ta company's expenses to manufacture its products. This is different from the cost of goods sold (COGS), which does not include all the goods a company has produced, but only the ones it has sold.

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COGM is calculated using direct labor, direct materials, manufacturing overhead, and work in process (WIP) inventory. The formula for calculating COGM is provided below:

COGM = BOP WIP + DL + DM + FO - EOP WIP

where,

  • BOP WIP = The work in process inventory at the beginning of the period
  • DL = Direct Labor
  • DM = Direct materials
  • FO = Factory Overhead
  • EOP WIP = Work in process inventory at the end of the period

Direct labor includes the wages of the employees that were directly working to produce the goods.

Direct materials are all the raw materials that are used in the creation of the products. For example, in a guitar company, direct materials would likely include both wood and guitar strings used in the finished product (the guitar).

Factory overhead is slightly more abstract. This includes the cost of running the machines used to create the products and the salaries of supervisors and managers. 
It includes the indirect costs that are associated with the production of goods. Machine use may be calculated by multiplying the number of hours a machine was used with the cost per hour for that machine. 

For example, if a company has a machine that can produce five units in an hour at the cost of $5 per hour, they would calculate their factory overhead rate per unit by dividing $5 per hour by the five units, which equates to $1 per product.

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The work-in-process inventory includes all products that are not yet finished or ready to be sold. The value of these products is calculated as the expenses that have already been incurred in their production. Subtracting the EOP WIP ensures that these costs are not counted twice in the production of these products.

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Linking COGM to COGS

A company's COGM is strongly tied to its cost of goods sold (COGS). COGS represents the expenses that a company incurs on behalf of the products it sells over a specified period of time. This does not include all COGM, but its calculation depends heavily on it.

After a product is manufactured, it is moved from work-in-process inventory to the finished goods inventory. COGS includes all finished goods that are sold to the public. The equation to calculate it is as follows:

COGS = BOP + COGM - EOP

where,

  • BOP = balance of finished goods at the beginning of the period.
  • EOP = Cost of finished goods at the end of the period.

The cost of goods sold is an important metric that can be found on the income statement of many companies. Often it is the first expense incurred, subtracted directly from gross earnings before other expenses.

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Why is COGM Important for Companies?

COGM is the cost of the materials, labor, and conversion costs that are incurred during production.

It helps companies better understand the cost incurred per unit of product and how much they need to produce to generate profits. It is especially helpful as part of the budget and planning process.

It can also help companies judge decide between launching new products or investing in the same product as it is part of the return on investment calculations.

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For example, if the COGM reveals that the overheads are the main reason for the losses, the company may be able to cover the loss by producing more of the product. On the other hand, if the material cost is higher than the product's sale price, it is best to discontinue the product and invest in other products or service lines.

Beyond this, it allows the management to scrutinize costs and implement changes that might help reduce COGM, thereby improving profits.

In many cases, budgets are not accurate. This means that companies sometimes spend slightly more or less money on production than was expected. However, this knowledge can be used to budget better in the future to understand the causes of these differences and aim to reduce costs.

It is also crucial for investors. Revenue does not necessarily mean profit, and understanding the costs associated with a company can help investors understand their investment opportunities better.

For instance, companies with high overheads might have a minimum level of sales required to stay in business, while those focusing on direct costs won't depend on such performance requirements.

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