Export Credit Refinance (ECR) Withdrawal - The Right Move

This post is a bit dated....ok, it’s very dated. I wrote it in February (when I first thought of creating my own blog), right after Governor Rajan announced the withdrawal of the Export Credit Refinance (ECR) facility. Then followed five months of procrastination. Fast toward to day - am finally posting it. 

This post is dedicated to understanding the erstwhile ECR facility - it’s concept, effectiveness and finally, the rationale behind its discontinuation.

ECR 101

Export Credit Refinance or ECR was a facility provided by the RBI to banks on the basis of their eligible outstanding rupee export credit (both at pre-shipment and post shipment phases). The quantum of the facility was fixed from time to time depending upon the stance of RBI’s monetary policy. ECR was repayable on demand or the expiry of a maximum term of 180 days. It was available at an interest rate = the Repo rate under the Liquidity Adjustment Facility (LAF). To avail of this facility, the borrowing bank had to provide a Demand Promissory Note (essentially a signed legal document where the maker i.e. bank unconditionally promised to pay a certain amount of money on demand to the holder i.e. RBI) along with other documents.

Lets take a real life example. Suppose the amount of ECR a bank could avail of was fixed at 50% of eligible export credit. This means that a bank that needed liquidity and had extended export credit of Rs. 100 crores, could go to the RBI and get Rs. 50 crores of refinance at the prevailing repo rate in exchange for a demand promissory note and other documentation. 

Purpose of ECR 

The key purpose of ECR was two-fold:

• It was a tool to augment liquidity for banks. In addition to borrowing at the repo rate under the LAF, banks with eligible export loan books could now also use the ECR facility to get funds at the same repo rate. 
• It was also a mechanism to encourage the flow of credit to the export sector. 

While the ECR helped achieve these objectives to an extent, its effectiveness in doing so has been limited. Lets understand why. 

How effective was ECR really?

Lets first examine the effectiveness of ECR as a tool to augment liquidity for banks. 

It’s well known that ECR was never the banks’ preferred instrument to meet liquidity requirements. The facility was rarely fully utilized. There are a couple of reasons for this – 

• ECR was useful only for banks with large export credit portfolios that needed to augment liquidity. A bank that did not have much export credit yet needed liquid funds, did not benefit from ECR. For example, PSU banks often had large export loan books, but tended to be comfortable on the liquidity front. Private or foreign banks on the other hand, may have need liquidity support, but may not have had an adequately large export credit portfolio to effectively utilise the ECR facility. 
• LAF Repo is the banks’ preferred borrowing tool to meet short-term liquidity needs. It’s easier, faster, independent of the size of the export loan book and does not require the kind of documentation that ECR did.

Next, let us look at the effectiveness of ECR as a tool to encourage credit flow to the export sector. 

• While ECR did enhance the flow of credit to the export sector to an extent, its impact was limited as could be deduced from the mostly unutilized limits of the ECR facility. As we discussed above, banks tended to shy away from utilizing ECR to meet their liquidity requirements. Consequently, ECR’s role in increasing credit flow to the export sector appears to have been stronger in theory than in practice. 
• For exporters what is key as far as export credit is concerned is the cost of funds. An increase in the ECR limit did not always translate into a proportional decrease in the loan rates offered to exporters, which are based on bank base rates (the minimum rate of interest that a bank charges from its customers) and take many other factors into account. 

Bottom-line, it is safe to say that the effectiveness of the ECR facility in achieving its stated objectives was limited. 

Move away from ECR was in the works already...

The Urjit Patel Committee (Urjit Patel is the Deputy Governor of the RBI) set up to review the RBI’s monetary policy framework, recommended last year that the RBI should move away from sector-specific refinance towards a more generalized provision of system liquidity without preferential access to any particular sector or entity. This would help improve the transmission of policy impulses across the interest rate spectrum and improve efficiency in cash management. 

This recommendation is not new. It is widely accepted that as money markets mature, emphasis on direct measures of monetary policy (such as sector-specific refinance) should weaken, and indirect policy instruments (such as LAF, Open market operations) should take centre-stage. Such a shift in emphasis in turn engenders further maturity and development of markets. It’s a virtuous cycle. 

Consequently, the RBI has wanted to move away from ECR for some time. Under Governor Rajan however, this goal finally came to fruition. In the monetary policy statement of June 2014, funds available under ECR were reduced from 50% to 32% of eligible export credit; in Oct 2014, they were cut to 15%; the ECR facility was finally withdrawn in Feb 2015. 

Conclusion

The decision to withdraw the ECR facility was eminently prudent. This facility was never the best tool to achieve either of its stated objectives.

Estimating "Value Added" from a "real life" Profit and Loss Statement

OK! So this is the post I’ve wanted to do for the past 12 days...i.e. ever since I inaugurated NerdVerve. 

In human time, that’s just 12 days. In nerd time, it’s like 12 years. 

So let’s get to it. 

Today, I will use a "real life" Profit and Loss Statement (Dabur India Limited’s FY15 statement - see Table 1) to calculate “Value added”. I use the words "real life" liberally in this sentence. It's called "nerd-etic" license. Yes, I made that up. 

Table 1: Dabur India Limited's FY15 Profit and Loss Statement

To estimate Intermediate Consumption, I’ll need to demystify the “Other Expenses” line item in the P/L (Profit and Loss) Statement above. Provided below is the break-up for “Other Expenses”.

Table 2: Break-up of "Other Expenses" line item in Dabur's P/L Statement

 We’ll also need data on the change in inventories. *Recites spell.

“Hokus pokus snippety dippety drump

Haloola paloola vanish Donald Trump”

*Data on change in inventories magically appears. 

Table 3: Change in Inventories of Finished Goods, WIP and Stock-in-trade

Finally, since we’ll also need Cost of Goods Sold (COGS) for this exercise, provided below is the P/L statement for Dabur presented in a slightly different format. This is the format that equity analysts use when they analyse company financials.

Table 4: Profit and Loss Statement for Dabur in a different format (breaks out COGS)

Perfect. Now, I’m going to post my excel worksheets where I estimate “Valued added” by Dabur india limited in FY15 from all the information provided above. The derivation process on the worksheets is methodical and accompanied by notes, which should make them self-explanatory if you’ve read my previous posts. Even if you havn’t, because I’m Awesim (Awesome + Simran), I’m going to discuss the key elements of the process  anyway. 

Bottom-line: you will not leave this page without understanding what I’ve done here. I won’t allow it.

Worksheet 1: Finding Gross Output 


Important Points: 

1. Basic Prices

Those of you who’ve read my post, Treatment of Inventories in National Income Accounting, will remember that per the SNA, Output should be estimated at Basic Prices. Basic Price = price received by producer - any product taxes (VAT, Sales tax, Excise duties etc.) + any product subsidies. The sales figures for Dabur are provided at Basic prices in the P/L. That said, strangely, in the “Other Expenses” break-up, I found two items: Sales tax (Rs. 11.5 Crore) and Commission, discount and rebate (Rs. 37.6 Crore). Even though per the notes to the P/L statement (in the Dabur annual report), these items should have been excluded from sales, they were not from some reason and included in “other expenses” instead. So, I’ve subtracted them from “Revenue from Operations” in order to get “Total Revenue” for our purpose. 

2. Other Income

I’ve also not included “Other Income” in Total Revenue (unlike in the Dabur P/L). While technically, Other Income which includes items like rent income & interest income, should be part of the output of the receiving enterprise, doing so in National Income accounting  can lead to double counting. This is because when we use the Production or “Value added” approach for measuring GDP, the interest and rent income received by Dabur is already counted as part of the value added by other enterprises (those that are paying out the rent and interest). Just like the interest and rent paid out by Dabur is part of it’s own Value added. In such a scenario, if we include Dabur’s rent and interest income in it’s output (and hence in its value added), we’ll be double counting. Also note that Other Income includes gain/losses on the sale of investments and fixed assets, which are not included in GDP/National Income.

3. Changes in Finished Goods (FG) and Work-in-Progress (WIP) Inventories 

Output = Sales revenue + Change in FG inventories + Change in WIP inventories. The changes in FG and WIP inventories (in FY15) provided in the Dabur annual report are at “Cost”. For the correct estimation of output, we need to estimate the change in FG and WIP inventories at Basic prices (per the SNA). 

i) How do we estimate the change in FG inventory at Basic prices? 

First, we need to find the COGS % (i.e. COGS/Sales) or the Gross Margin (%) for Dabur. Note: GM (%) = 1 - COGS/Sales. You can see from Table 4 (look at the stand-alone figure for 2014-15) that COGS = Rs. 2,826.1 Crore. For Sales, we’ll use the "Total Revenue" figure from my worksheet (Rs. 5,382.1 Crore), which is at Basic prices. COGS/Total Revenue = 52.5%. 

Now, the change in FG inventory (Rs. 40.7 Crore) is recorded at cost in Dabur’s financial statements. This means that the cost of each unit of FG inventory = COGS/unit. This further means, that to write up the value of change in FG inventory to Basic prices, we should divide the change in inventory by the COGS % (COGS/Sales) ---> 40.7/52.5% = Rs. 77.4 Crore. Voila! Rs. 77.4 Crore is thus the value of change in FG inventory at Basic prices. 

ii) How do we estimate the change in WIP inventory at Basic prices? 

The value of change in WIP inventory at cost is (-) Rs. 11.3 crore. The value of this WIP inventory at Basic prices = -11.3 /52.5% = (-) Rs. 21.5 Crore. 

4. Gross Output

Output = Total Revenue (at Basic prices) + Change in FG inventories (at Basic price) + Change in WIP inventories (at Basic prices). I’ve called this Gross Output because we havn’t excluded depreciation from this Output number. 

Worksheet 2: Finding Intermediate Consumption 

Important Points: 

1. Formula for Intermediate Consumption 

Read my previous post, What is Intermediate Consumption? And how is it different from COGS?, to understand what Intermediate Consumption means. The formula for estimating Intermediate Consumption (specific to this example given the information provided) is:

Intermediate Consumption = Cost of materials consumed + cost of Stock-in-Trade consumed + cost of Stores/spares consumed + Other bought-in goods and services. 

2. Cost of Materials Consumed

Many a times, a P/L statement gives us the cost of “Purchases” of materials. The value of “materials consumed” (for producing Output) is then derived like this: Materials consumed = Material purchases - (Ending Inventory of material - Beginning Inventory of materials). Since in Dabur’s P/L, we’re already given the value of materials consumed, we can use it directly and don’t need to perform any calculation.

3. Cost of Stock-in-Trade (SIT) Consumed

Purchases of SIT inventory (provided in P/L) = Rs. 937.3; Change in SIT inventory = Rs. 2.9 Crore (also in P/L). Hence, Cost of SIT consumed = 937.3 - 2.9 = Rs. 934.4 Crore. 

4. Cost of Stores and spares Consumed

I’ve pulled this figure out of the “Other Expenses” head. 

5. We won’t subtract changes in FG and WIP inventory

You’ll notice in Dabur’s P/L statement that the changes FG and WIP inventories have been subtracted from the Expenses head to get “Total Expenses”. The reason this has been done is because P/L statements list expenses related to the Sales made during the period. Hence from total expenses, the cost of changes in FG and WIP inventory needs to subtracted since these costs cannot be attributed to sales. We on the other hand, are estimating costs for “Gross Output” produced, which includes changes in FG and WIP inventories. Hence, we don’t need to subtract the cost of changes in FG and WIP inventories when we calculate Intermediate Consumption. 

6. Other bought-in goods and services 

Here I’ve listed all the other goods and services purchased by Dabur from outsiders e.g. power and fuel, repairs to building, plant & machinery (I’m assuming here that this includes tools/goods and services purchased from outsiders. Supposing this head includes the salaries for a repairs technician employed by Dabur, then this would have to be excluded from intermediate consumption. However, in the absence of this level of detail, assuming that repairs included goods/services bought from outsiders is a good assumption), processing charges, insurance, freight and forwarding charges, advertising and publicity, travel charges, legal and professional fees, security expenses etc.

Worksheet 3: Finding Value Added

Finally, Valued Added by Dabur India Limited in FY15 = Rs. 1,628.3 Crore. 

Booyah!! 

Who’s the nerd?

I am. * Hi-fives self.

What is Intermediate Consumption? And how is it different from COGS?

Do you know what I discussed in my last post - What is Cost of Goods Sold (COGS) and how is it calculated?

Come on! You can do it. At least venture a guess. 

No? 

I talked about COGS and how it’s calculated. 

I also cracked a lot of COGS jokes, just COgS I could. But COGS is just a COGs in the wheel. There’s much more to understand and explore. 

So, as promised in my last post, I’m now going to talk about Intermediate Consumption. 

Intermediate Consumption is the value of goods and services (which are used up in the process of production) purchased by a production unit from outsiders. 

The SNA says this about Intermediate Consumption:

“Intermediate consumption consists of the value of the goods and services consumed as inputs by a process of production, excluding fixed assets whose consumption is recorded as consumption of fixed capital. The goods or services may be either transformed or used up by the production process. Some inputs re-emerge after having been transformed and incorporated into the outputs; for example, grain may be transformed into flour which in turn may be transformed into bread. Other inputs are completely consumed or used up; for example, electricity and most services.” 

For a production unit that makes furniture for instance, the cost of wood, nails, adhesive, paint etc. is all part of Intermediate Consumption. So are the costs incurred on power, rent, insurance of the production facility, repair and maintenance of equipment etc. Basically, any good or service bought from outsiders (as opposed to being producing in-house) that is used in the production process (directly or indirectly) is included in Intermediate Consumption. Note: as mentioned above, capital investments such as building another room in the furniture production unit, or buying expensive machinery that helps in the furniture making process are not included in Intermediate Consumption. Neither is the depreciation charged to them. 

The reason the concept of Intermediate Consumption is important is because: Output - Intermediate Consumption = Valued Added. And, the sum of the value added by all the production units in a country gives us its GDP. 

Timing and Valuation of Intermediate Consumption

Per the SNA:

“The intermediate consumption of a good or service is recorded at the time when the good or service enters the process of production, as distinct from the time it was acquired by the producer. In practice, the two times coincide for inputs of services, but not for goods, which may be acquired some time in advance of their use in production. A good or service consumed as an intermediate input is normally valued at the purchaser’s price prevailing at the time it enters the process of production; that is, at the price the producer would have to pay to replace it at the time it is used. ” 

This of course is ideally how Intermediate Consumption should be valued for the purpose of estimating “Value Added”. That said, since value added is usually estimated from the financial statements of business enterprises, and the purchases made by them are valued at cost in these statements (Profit and Loss Account), this guideline is hard to implement.

How is Intermediate Consumption different from COGS? 

Now that we understand both concepts (read my post What is Cost of Goods Sold (COGS) and how is it calculated? for a detailed understanding of COGS), it is easier to differentiate between the two:

• While no wages/ salaries are included in Intermediate Consumption, COGS does include the wages of those working directly on the product or service. For example, wages of factory workers in a manufacturing enterprise are included in COGS. 

• Intermediate Consumption includes the value of all the goods or services used as inputs (purchased from outside the enterprise) into ancillary activities such as purchasing, sales, marketing, accounting, data processing, transportation, storage, maintenance, security, etc. In fact, any good or service bought from outside the enterprise (excluding capital goods) and utilized either directly for production or for any related ancillary activity is included in Intermediate Consumption. This is not the case for COGS. Only those purchased goods which are used directly in the production process are included in COGS. Also, only the overheads (power, water, rent etc.) for the manufacturing area can be included in COGS. 

• COGS is a financial concept, whereas Intermediate Consumption is an economic concept. 

• As is evident from our discussion above, Intermediate Consumption is a much broader concept as compared to COGS. 

I think this brief introduction to Intermediate Consumption, and its quick match-up with COGS is enough for now. I could go on.....but I feel like I should exercise restraint. 

Especially since in my next post, I’m going to convert a real-life (not living and breathing unfortunately, but a bonafide FY15 P&L statement of a company) Profit and Loss Statement into a Value Added Statement using the concepts we’ve learnt so far (Output, Intermediate Consumption, COGS).

#soexcited #nerdsjustwannahavefun #canyoufeelthenerdtonight 

How to Calculate Cost of Goods Sold (COGS) with Example

Definition: Cost of Goods Sold (COGS) is the sum of the Direct costs and Manufacturing Overhead attributable to the production of goods sold by a company. It includes:

1. Cost of direct labour (wages for workers working directly on the product being manufactured)
2. Cost of direct materials (materials, components used in the manufacturing of the product) 
3. Manufacturing Overhead attributable to the product's manufacturing process.

We are going to dig deep into COGS, but feel free to jump to any section you want to:  

• What is included Cost of Goods Sold?
  

• Why is Cost of Goods Sold Important?

• Formula for Cost of Goods Sold

• Accounting Methods for Cost of Goods Sold: FIFO and LIFO

• LIFO vs. FIFO: Advantages and Disadvantages

• Detailed COGS Calculation for Manufacturing Company

What is included in Cost of Goods Sold? 

Very simply, Cost of Goods Sold = Direct Costs + Manufacturing Overhead.

In this section, we describe in detail what these components mean, and what they include. 

Source: The Economics Journey

1. Direct costs

Direct costs of production are those costs that can be easily attributed to specific Cost objects i.e. specific final products and services.

These include:

1. The cost of direct labour i.e. wages of factory workers working directly on manufacturing the product on the shop floor.


2. The cost of direct materials i.e. materials and components used directly in the manufacturing of the product.

These costs can be attributed to the manufacturing of the product with a high level of accuracy and little effort. They form part of the COGS for the product.

• Example

Let us assume that factory 'A' manufactures washing machines and microwave ovens. We want to determine the Cost of Goods Sold for washing machines produced in this factory.

The wages paid to factory workers involved directly in the manufacture of washing machines (i.e. in the fabrication, sub-assembly and assembly of washing machines) and materials used specifically in the manufacture of washing machines (such as steel sheets, plastic, aluminium, rubber hoses, prefabricated motors and electronic controls) are Direct costs.

These costs can be attributed accurately and with ease to the manufacture of washing machines, and form part of the COGS for washing machines.

2. Manufacturing Overhead 

Overhead (or Indirect cost) on the other hand, is comprised of costs that cannot be accurately attributed to specific Cost objects with ease.

Overhead is of two types: i) Manufacturing Overhead, and ii) Corporate Overhead.

Only Manufacturing Overhead is included in COGS.



Source: The Economics Journey

• Components of Manufacturing Overhead

Manufacturing Overhead (or Factory Overhead) includes manufacturing costs (or factory costs) that cannot be easily attributed to specific Cost objects.

Since direct labour and direct materials are the only costs in a factory that are considered Direct Costs (i.e. easily attributable), all the other costs of running the factory are usually included in Manufacturing Overhead.

Manufacturing Overhead includes:

1. Rent paid for the factory 
2. Electricity, water and other utility bills for the factory
3. Factory insurance
4. Factory depreciation charge 
5. Property tax for the factory
6. Factory supplies not related to manufacturing (e.g. stationary, sanitation supplies) 
7. Salaries of the factory manager, quality control, maintenance, security, administrative, janitorial and other non-manufacturing staff.

• How is Manufacturing Overhead calculated? 

If only one product is produced at a factory, it is easy to calculate Manufacturing Overhead for this product. All one has to do is identity all the expenses (listed above) included in Manufacturing Overhead, and sum them up.

However, if multiple products are produced at a factory, then the entire Manufacturing Overhead is not attributable to any single product. This is when judgement has to be exercised. 

There are two ways of allocating Manufacturing Overhead:

1. In proportion to the number of labour hours needed to produce one unit. (This method is used when the manufacturing process is labour intensive)

2. In proportion to the number of machine hours needed to produce one unit. (This method is used when the manufacturing process is mostly automated and the need for direct labour is low)

• Example of Manufacturing Overhead Allocation  

Let us use the same example of factory 'A' that manufactures washing machines and microwave ovens. We have to estimate Manufacturing Overhead attributable to washing machines.

The manufacturing process for both washing machines and microwave ovens is highly automated. So it makes sense assign to Manufacturing Overhead in proportion to the number of machine hours used per unit.

Data Available:

Allocation in proportion to machine hours used: 

Total no. of machine hours used for manufacturing washing machines = 100 x 20 = 2,000

Total no. of machine hours used for manufacturing microwave ovens = 50 x 25 = 1,250

Machine hours used for washing machines as % of total machine hours used = 2,000/ (2,000 +1,250) = 62%

Hence,

Manufacturing Overhead attributable to washing machines:

= 62% x Rs 50,000 = Rs 31,000

Manufacturing Overhead per washing machine unit:

= Rs 50,000/ 100  = Rs 500

A short Note on Corporate Overhead (not included in COGS)

We know that besides Manufacturing Overhead, that comprises of all the indirect costs incurred in the factory, there is another type of Overhead called 'Corporate Overhead'.

Corporate Overhead comprises of all the indirect business expenses (not part of actual production expense) incurred outside of the factory, that are required to run the firm.  

These include:

1. Sales force costs
2. office administrative costs
3. head-office and regional office manager salaries
4. administrative staff salaries
5. utilities cost for the regional and head offices
6. interest charges  for the firm
7. marketing costs
8. legal fees
9. insurance charges for the firm 

As stated before, Corporate Overhead is not part of COGS.

Why is Cost of Goods Sold Important?

Cost of Goods Sold is important because subtracting COGS from the Sales of a company, gives us its Gross Profit. Gross Margin (GM) which is = Gross Profit/ Sales, is a very important profitability metric for a business. It is used by owners, investors and others stakeholders to company evaluate performance. Company management teams will often set Gross Margin targets for future years in order to improve cost control, increase profit metrics and please investors who see rising GMs as a sign of future profitability and cash flows.

Gross Margin (%) = Gross Profit / Sales = (Sales - COGS) /Sales

Formula for Cost of Goods Sold

The incomplete identity that most texts provide is: Beginning inventory + Purchases = COGS + Ending Inventory. 

This is only part of the picture and an over-simplification, as I’m sure you’ll agree if you’ve read thus far. The calculation of Cost of Goods Sold for a business needs to account for direct labour costs and overhead related to manufacturing as well. 

The complete identity to calculate Cost of Goods Sold is: Beginning Inventory + Purchases + Direct labour costs + Overhead (manufacturing) = COGS + Ending Inventory           or

Cost of Goods Sold = Purchases + Direct labour costs + Overhead (manufacturing) - (Ending           Inventory - Beginning Inventory) 

Where:

• Beginning & Ending Inventory include all three kinds of inventory: 1) Materials/supplies used to manufacture the finished good, 2) Work-in-progress (items that are in process but aren’t finished), and 3) Finished goods (completed products that are ready for sale). 

• Purchases include all materials, supplies and other inputs purchased for the manufacturing of the product. 

• Direct labour costs include wages and benefits of factory workers involved directly in manufacturing the product. 

• Overhead includes rent, electricity and other expenses related specifically to the operation of the manufacturing area for the product. 

Accounting Methods for Cost of Goods Sold: FIFO and LIFO 

The value of COGS depends on the Inventory accounting method employed by a company. There are 2 main methods to account for inventory and by implication, Cost of Goods Sold.

1. First-in-first-out (FIFO) 

In the FIFO method, it is assumed that the inventory acquired first, is sold first. Let's explain with an example. Suppose firm ‘A’ manufactures pearl earrings. It buys pearls from a vendor (uses 1 pearl per earring), transforms them into earrings at its facility and then sells them at the local market. At the beginning of 2015, ‘A’ had a beginning inventory of 10 pearls, bought at Rs 100 each. A’s pearl purchases during 2015 were as follows:

• Purchase data for FIFO Inventory & COGS Calculation

• Calculation of FIFO Inventory & COGS  

Now lets assume 60 earrings (30 pairs) are sold in 2015. Per FIFO accounting rules, the pearls acquired first, will be charged to sales first. This means that the 60 pearls used in the earrings sold in 2015 will include the 10 in beginning inventory, the 10 bought in Jan, the 20 bought in Mar, and 20 from the pearls bought in July.

• COGS:  The total cost of pearls included in COGS will be = Rs. 10 x 100 + 10 x 110 + 20 x 120 + 20 x 125 = Rs. 7,000. 

• Ending Inventory: The ending inventory of pearls will be = cost of pearls left  = Rs. 10 x 125 + 10 x 130 = Rs. 2,550. 

2. Last-in-first-out (LIFO)

In the LIFO method, it is assumed that the inventory acquired last, is sold first. Let's use the same example as above.

• Calculation of LIFO Inventory & COGS  

• COGS:  If 60 earrings are sold in 2015, the total cost of pearls included in COGS will be = Rs. 10 x 130 + 30 x 125 + 20 x 120 = Rs. 7,450.

• Ending Inventory: The ending inventory of pearls will be = cost of pearls left  = Rs. 10 x 110 + 10 x 100 = Rs. 2,100. 

LIFO vs. FIFO: Advantages and Disadvantages  

The FIFO method is the more widely used method of Inventory accounting. The reasons are provided below.

LIFO 

• Lower taxes, higher cash (Advantage): Prices usually rise over time, like we’ve assumed in our example above. In such an environment, the LIFO method charges the most-recent, higher-cost purchases and inventory to sales, giving a higher Cost of Goods Sold and lower Net profit. The advantage of using this method then (vs. FIFO accounting) is that companies pay lower tax (tax is calculated off the net profit value) and thus have higher cash balances. 

• Outdated Inventory values (Disadvantage): Since the oldest products are left in inventory under LIFO, over time, Inventory values can get quite outdated (especially when prices or are technology is changing quickly). The LIFO method can also lead to Inventory Obsolescence.

• Potential for manipulation (Disadvantage). LIFO has been used by companies in the past to manipulate earnings and mislead investors. This happens when companies conduct a planned LIFO liquidation where they purchase less that they sell, so that can charge low-cost, old inventory to current sales and artificially inflate profits. 

• Banned under IFRS (Disadvantage).  While allowed under US GAAP, LIFO accounting is banned under IFRS (most of the world uses IFRS) because of the reasons mentioned above - 1) its use to lower profits to reduce tax liability, 2) outdated and obsolete inventory, 3) potential for earnings manipulation. 

• Not feasible for perishable products (Disadvantage). LIFO is not advisable for perishable product businesses since the oldest products kept in inventory can expire before they're sold, leading to losses for the company.   

FIFO 

• Higher taxes, lower cash (Disadvantage): In an inflationary environment, since the FIFO method charges the oldest inventory and purchases to sales first, giving a lower Cost of Goods Sold and higher Net profit (vs. LIFO), companies using FIFO pay higher tax and have lower cash balances. 

• Inventory values aligned with market (Advantage): Since the most recently manufactured products reside in inventory, inventory values reflect market reality more accurately than the LIFO method. The chances of inventory obsolescence are also much lower. 

• Companies cannot manipulate earnings (Advantage). Under the FIFO method, companies cannot manipulate earnings by choosing which units to ship as opposed to LIFO, where LIFO liquidations can be used to inflate profits. 

• Recommended for perishable products (Advantage). FIFO is recommended for perishable product businesses since the oldest products (at risk of expiry of shelf life) are shipped first. 

• More widely used than LIFO (Advantage). Given all the advantages mentioned above, and the fact that LIFO is banned by the IFRS, the FIFO method is more widely used than LIFO. 

Example of Detailed COGS Calculation for Manufacturing Company

Now that you have the requisite theoretical background, we're going to do a detailed, step-by-step calculation of the Cost of Goods Sold for a manufacturing business. We're going to use FIFO accounting for inventory.

Let’s assume that you own a firm A. You’ve tasked an Accountant with calculating the Cost of Goods Sold by you firm for 2015. Here’s the data you have, and what you present to the Accountant:

1. Data available to Accountant for estimating Cost of Goods Sold

As shown in the table above, the data available includes:

• Beginning Inventory for 2015 (Both units and cost/unit for the firm's 2014 Ending Inventory is available in the firm’s financial statements - this is Beginning Inventory for 2015). 

• Purchase of materials (Both units and cost/unit are available. The firm uses 1 unit of material per unit of finished goods produced). 

• Direct labour costs (Companies usually multiply the hours worked by manufacturing workers by their hourly wage rate to get direct labour costs). 

• Manufacturing Overhead (This is not as straightforward to determine as the other components. Accountants will often assign a certain percentage of the total utility, rent and other overhead costs of a factory, to a specific final product). 

• Ending Inventory for 2015 (Only units are available. The accountant will have to calculate cost/ unit. We will illustrate how to do this in this example).

2. Accountant first calculates Cost/unit (of Finished goods) Produced

In order do this, he first calculates the number of units of Finished goods (FG) produced in 2015.

• Number of units (of Finished goods) produced

He assumes (upon inspection) that the WIP units lying in both Beginning and Ending inventory are 70% complete - he treats these as 70% of a Finished good (FG), in his calculations.

Mathematically, he knows that:

No. of FG units produced during the year = No. of FG units sold during the year + No. of FG units in Ending Inventory - No. of FG units in Beginning Inventory 

Using this identity, for firm A, he calculates:

No. of FG units in Beginning Inventory = 10 + 70% *15 = 20.5 

No. of FG units in Ending Inventory = 5 + 70% *5 = 8.5

Plugging these values into the identity above, he gets: 

No. of FG units produced in 2015 = 135 + 8.5 - 20.5= 123

• Cost/unit (of Finished Goods) produced

To estimate Cost/unit of finished goods produced during 2015,  the Accountant calculates and sums up the cost of materials used/unit, direct labour used/unit and manufacturing overhead/unit of FG produced. 

Since 1 unit of material is used per unit of FG, Cost of materials used per unit of FG = Rs 6/unit. (Given)

Cost of direct labour used per unit of FG produced = 400/123 = Rs 3.3

Cost of overhead per unit of FG produced = 300/123 = Rs 2.4

Consequently, 

Cost per unit of FG produced in 2015 = 6 + 3.3 + 2.4 = Rs 11.7

3. Accountant applies FIFO accounting principles to Unit cost Calculations to derive COGS

• The Cost of Goods Sold is not = the cost of goods produced in 2015, because per the FIFO method, Finished goods in Beginning Inventory (BI) are sold first. Beginning Inventory for the firm includes 10 units of FG, 15 units of WIP and 30 units of materials, with Total cost of Beginning Inventory = Rs 355. 

• The WIP units are 70% complete. The Accountant estimates that the Cost of processing WIP units into FG in 2015 = Rs. 11.7 x 30% x 15 = Rs 52.6. 

• The cost of converting each unit of material in BI into FG = Cost of direct labour used per unit of FG + Cost of overhead per unit of FG = Rs 3.3 + 2.4 = Rs 5.7. Hence, Cost of converting all materials in BI into FG = Rs 5.7 x 30 = Rs 170.7. 

• Consequently, the Accountant estimates that the 135 units of finished goods sold in 2015, included 55 units (10+15+30) from Beginning Inventory (FG as well as WIP and materials processed into FG), which cost Rs 355 to begin with, and a further 223.3 (52.6 + 170.7) to convert to finished goods. Hence, the Total cost of the 55 units of FG sold from BI = 355 + 223.3 = Rs 578.3. 

• The remaining 80 units sold (135-55), cost Rs 11.7 per unit or Rs 935.3 (11.7 x 55) to produce. 

• Hence, the Cost of Goods Sold in 2015 = 578.3 + 935.3 = Rs 1,513.6 

4. Accountant applies FIFO accounting principles to Unit cost Calculations to derive cost of Ending Inventory

Given that per FIFO, Ending Inventory (EI) includes the most recently produced goods, the cost of EI is easy to calculate now. 

EI for firm A includes 5 units of FG (cost = 5 x 11.7 = Rs. 58.5), 5 units of WIP (cost = 5 x 11.7 x 70% = Rs 40.9) and 18 units of materials (cost = 18 x 6 = Rs 108).

Hence, Total cost of Ending Inventory = 58.5 + 40.9 + 108 = Rs 207.4.

5. Accountant Verifies calculations against the Cost of Goods Sold Identity

COGS= Purchases + Direct labour costs + Overhead (manufacturing) - (Ending Inventory - Beginning Inventory)

The Accountant verifies his calculations against the COGS identity (reproduced above) to make sure that his calculations are mathematically correct. 

RHS = 666 + 400 + 300 -206.4 + 355 = 1,513.6

LHS = 1,513.6

Hence verified.