In our previous blogs, we spent a significant amount of time in understanding Revenue recognition policies. Since Accounting standards have been very explicit in what should be recognised as revenue and what shouldn't, they have taken similar efforts on the expenses side to ensure the financial statements are represented and governed by standard principles. This is called Expense matching principle, which explicitly mentions that only those expenses can be recorded on the Income statement which correspond to the revenue recognised and were incurred to generate that revenue for the entity in the given time period. Let’s take a very simple example, where, we have bought goods worth 1000 rupees and were able to sell only 60% of those for 800 INR. From revenue recognition, we will recognise 800 rupees as Revenue but not the entire 1000 will go for the corresponding expense, but only 60% of overall 1000 will be recognised as expense on the income statement as per the requirement under expense matching principle i.e. 600 INR. Remaining 400 will sit on Balance sheet as Inventory. In the next accounting period, when the remaining 40% goods are sold, this 400 rupees will be recognised as an expense on the Income statement.
Now that we understand these accounting basics, let's go through the basics around Inventory and COGS. Inventory on the balance sheet is often represented via 4 sub categories:
Work In Progress
Stock in trade: This would seem new to you as it's found only in listed Indian companies' financials. It basically indicates the amount of goods you directly purchased/ outsourced from other companies and are going to sell (Trading goods).
Information and quantum of all these subcategories of inventory can be extracted from the footnote of inventory.
At times, Companies may choose to add more subcategories based on their preferences like Stores and spares based on their judgement (else they may be clubbed within the four categories).
Case Study: VIP Industries
Below is the snapshot of the inventory footnote of VIP Industries. As explained earlier, the firm has chosen to add more subcategories in their inventory footnotes such as “In transit” categories and stores and spares. However, more or less every category revolves around the ones we saw earlier.
Let's understand the flow of how Inventories change buckets within the categories we saw earlier.
Raw materials, once we start working upon them, shift to the category of Work in progress which eventually gets worked upon, till the end, to be ready for sale, a category which is called Finished goods. To explain from the above flow how Cost of Goods Sold is calculated, we have taken a simple example.
Let’s say the year starts with Rs. 100 worth units in RM, Rs 50 worth of units in work in progress, Rs 50 worth of units in Finished goods and Rs 20 worth of units in Stock in trade.
When the year ends, we have 200 worth units in RM, 30 in work in progress, 80 in Finished goods and 30 in Stock in trade.
Thus, from above, COGS = Cost of Finished goods consumed + Cost of Stock in trade consumed
COGS = 190 + 30 = 220
One would expect to see a single line item on P&L called COGS like we do in case of any other global companies, however, as per the mandate by Indian Accounting standards, the representation of COGS is not one single line item, but it's broken down in three line items
Cost of Raw materials consumed
Change in WIP, FG & stock in trade
Let us explain how these three would amount in total to COGS.
To compute COGS, we would be needing Cost of Finished goods consumed/sold & Cost of Stock in trade consumed/sold as they are the only ones which are sold out.
Thus, Cost of Goods sold = Amount of goods transferred out of Finished goods + Amount of goods transferred out of Stock in Trade
Substituting from previous discussions,
Cost of Goods Sold = Opening FG - Closing FG + Raw material purchases + Opening RM - Closing RM + Opening WIP -Closing WIP + Opening Stock in Trade - Closing Stock in Trade + Purchases
Cost of Goods Sold = Change in WIP, FG & SIT + Purchases + RM purchases + Opening RM - Closing RM
COGS = Cost of Raw Materials Consumed + Purchases + Change in WIP, FG & SIT
We can verify this numerically from above example
COGS = Cost of Raw Materials Consumed (200) + Purchases (40) + Change in WIP, FG & SIT (50-30+ 50-80+20-30)
COGS = 200+40-20 = 220. Matches to our previous calculations!
Knowing COGS computations is extremely crucial. Knowing backstage computation of these three line items summing up to COGS, helps us gather a good understanding of the mix of products which are being sold and compute their COGS accordingly i.e. Manufacturing COGS and Trading COGS. Lets try and apply our understanding of COGS to a listed Indian company and calculate its manufacturing and trading margins over a period of time. Please read our blog 118 - Calculating Manufacturing and Traded Margins for the same.