Praction Group » Forecasting Cost of Goods Sold: A Comprehensive Guide for Businesses

By Jeff Plowman, Praction Group founder

Accurately forecasting the Cost of Goods Sold (COGS) is crucial for businesses of all sizes to maintain profitability and make informed financial decisions. This blog post will delve into the intricacies of COGS forecasting, including breaking down costs by revenue driver, identifying indirect COGS, and exploring various methodologies suitable for different industries and product types.

The Importance of Breaking Down Costs by Revenue Driver

Understanding the specific costs associated with each revenue driver is essential for accurate COGS forecasting. By breaking down costs in detail, businesses can gain valuable insights into their cost structure and make more informed decisions.

For example, a small bakery might break down its COGS into the following categories:

Raw ingredients (flour, sugar, eggs, etc.)
Packaging materials
Direct labor costs
Equipment depreciation

By analyzing these components separately, the bakery owner can identify which areas are most impacting their COGS and focus on optimizing those specific costs.

Now let's consider "Elite Plumbing Solutions," a company that caters to high-end residential, commercial, and service customers. By breaking down their COGS for each revenue stream, they can gain valuable insights:

High-end Residential:
- Premium fixtures and materials
- Skilled labor costs
- Transportation to upscale neighborhoods
- Specialized tools for custom installations

Commercial:
- Industrial-grade materials
- Labor costs (often requiring teams)
- Heavy equipment rental or depreciation
- Project management costs

Service Calls:
- Replacement parts inventory
- Labor costs (usually single technician)
- Vehicle maintenance and fuel
- Emergency response equipment

By analyzing these components separately, Elite Plumbing Solutions can identify which revenue stream is most profitable and where costs can be optimized. For instance, they might find that their high-end residential jobs have the highest profit margin due to the premium pricing, while service calls have lower margins but provide steady cash flow.

Identifying Indirect COGS and Allocations

While direct costs are easily attributable to specific products or services, indirect costs require more careful consideration and allocation.

Indirect costs, also known as overhead costs, can include:

Rent for production facilities
Utilities
Maintenance and repairs
Quality control expenses

To allocate these indirect costs, businesses can use various methods:

Fixed Cost Classification: This simple method allocates fixed costs to specific assets or departments. For instance, a small manufacturing company might allocate depreciation expenses for machinery directly to the production department

Proportional Allocation: This method assigns a percentage of indirect costs to different departments based on relevant factors. A software development company might allocate office rent based on the square footage used by each team

Activity-Based Cost Allocation: This more detailed approach involves identifying and recording each business activity and categorizing them as direct or indirect costs. While time-consuming, it provides a more accurate allocation of indirect costs

Continuing with our Elite Plumbing Solutions example, let's examine how they might handle indirect costs and allocations:

Indirect costs for Elite Plumbing Solutions might include:

Office rent and utilities
Administrative staff salaries
Marketing and advertising expenses
Insurance premiums
Training and certification costs for plumbers

To allocate these indirect costs, Elite Plumbing Solutions could use the following methods:

Fixed Cost Classification: The company might allocate the depreciation of specialized equipment (like hydro-jetting machines) directly to the commercial plumbing department, as it's primarily used for those jobs.

Proportional Allocation: Office rent and utilities could be allocated based on the revenue generated by each division. If high-end residential jobs account for 50% of revenue, they would be allocated 50% of these costs.

Activity-Based Cost Allocation: For marketing expenses, Elite Plumbing Solutions might track the specific campaigns and allocate costs based on which division they target. A luxury home magazine ad would be allocated to the high-end residential division, while a radio spot for emergency services would be allocated to the service call division.

By carefully allocating these indirect costs, Elite Plumbing Solutions can get a more accurate picture of the profitability of each division. This could lead to strategic decisions, such as focusing more resources on the most profitable areas or identifying ways to reduce costs in less profitable segments.

For example, they might discover that their commercial division has higher indirect costs due to the need for more administrative support and project management. This insight could lead them to either adjust their pricing for commercial jobs or look for ways to streamline their processes to reduce these indirect costs.

Forecasting Methodologies and Their Applicability

Different industries and product types may require varying approaches to COGS forecasting. Here are some common methodologies:

Percentage of Sales Method: This simple approach uses historical COGS as a percentage of sales revenue to predict future COGS. It's particularly useful for small businesses with stable cost structures

Trend Projection: This technique analyzes historical data to detect patterns and is best suited for businesses with at least 24 months of sales history

Econometric Forecasting: This complex method uses mathematical formulations to analyze various factors affecting COGS. It's more suitable for larger businesses with access to extensive data and analytical resources
Qualitative Methods: These include techniques like the Delphi model, which relies on expert opinions, and market research. They can be particularly useful for new products or services without historical data.

Applying COGS Forecasting to Small Businesses

Small businesses can benefit significantly from accurate COGS forecasting, even with limited resources. Here's how they can approach it:

Start with the Basics: Begin by tracking all direct costs associated with producing goods or services. For a small clothing boutique, this might include the cost of fabrics, buttons, zippers, and direct labor.

Identify Key Cost Drivers: Determine which factors most significantly impact your COGS. For a small restaurant, this could be food costs, which fluctuate based on market prices and seasonality.

Use Simple Forecasting Methods: The percentage of sales method can be an excellent starting point for many small businesses. For example, if a small online retailer's COGS has consistently been 60% of sales revenue, they can use this percentage to forecast future COGS based on projected sales.

Regularly Review and Adjust: Small businesses should review their COGS forecasts regularly and adjust as needed. A small craft brewery might need to adjust its forecasts if there's a sudden increase in the price of hops or other key ingredients.

Consider Technology: Even small businesses can benefit from inventory management and forecasting software. A small electronics repair shop could use such tools to track parts usage and predict future needs more accurately.

Real-World Examples

Let's look at some real-world examples of how businesses apply COGS forecasting:

Apple: The tech giant effectively manages its COGS by controlling its supply chain. By manufacturing many of its own components and negotiating favorable contracts with suppliers, Apple keeps its COGS low relative to its revenue

Amazon: The e-commerce leader uses data analytics to understand product demand and adjust inventory accordingly. This lean inventory management helps keep storage and handling costs low, directly impacting COGS

ABC Electronics: This global manufacturer implemented efficient supply chain processes and just-in-time inventory management to reduce raw material costs and minimize obsolescence risk, ultimately lowering their COGS

XYZ Clothing: By implementing lean manufacturing principles, this apparel brand optimized its production processes, reducing waste and improving efficiency. This approach allowed them to decrease COGS without compromising product quality

To summarize, forecasting COGS is a critical process for businesses of all sizes. By breaking down costs by revenue driver, accurately allocating indirect costs, and choosing the right forecasting methodology, companies can gain valuable insights into their cost structure and make informed decisions to improve profitability. Whether you're a small bakery, a large manufacturing company or a commercial plumbing company, investing time and resources into COGS forecasting can yield significant benefits for your business. Contact Praction Group to find out how you can take the next step in understanding your business at a deeper level to maximize profitability.