What Is Cost of Goods Sold – COGS?

Cost of goods sold (COGS) refers to the direct costs of producing the goods sold by a company.
This amount includes the cost of the materials and labor directly used to create the good. It
excludes indirect expenses, such as distribution costs and sales force costs.

Cost of goods sold is also referred to as "cost of sales."

KEY TAKEAWAYS

 Cost of goods sold (COGS) includes all of the costs and expenses directly related to the
production of goods.
 COGS excludes indirect costs such as overhead and sales & marketing.
 COGS is deducted from revenues (sales) in order to calculate gross profit and gross
margin. Higher COGS results in lower margins.
 The value of COGS will change depending on the accounting standards used in the
calculation.

Formula and Calculation for COGS

COGS=Beginning Inventory + P− Ending Inventory
where
P=Purchases during the period
What Does the COGS Tell You?

The COGS is an important metric on the financial statements as it is subtracted from a

company’s revenues to determine its gross profit. The gross profit is a profitability measure that
evaluates how efficient a company is in managing its labor and supplies in the production
process.

If COGS increases, net income will decrease. While this movement is beneficial for income tax
purposes, the business will have less profit for its shareholders. Businesses thus try to keep their
COGS low so that net profits will be higher.

For example, the COGS for an automaker would include the material costs for the parts that go
into making the car plus the labor costs used to put the car together. The cost of sending the cars
to dealerships and the cost of the labor used to sell the car would be excluded.

Furthermore, costs incurred on the cars that were not sold during the year will not be included
when calculating COGS, whether the costs are direct or indirect. In other words, COGS includes
the direct cost of producing goods or services that were purchased by customers during the year.
Accounting Methods and COGS

The value of the cost of goods sold depends on the inventory costing method adopted by a
company. There are three methods that a company can use when recording the level of inventory
sold during a period: First in, First Out (FIFO), Last in, First Out (LIFO), and the Average Cost
Method.

FIFO
The earliest goods to be purchased or manufactured are sold first. Since prices tend to go up over
time, a company that uses the FIFO method will sell its least expensive products first, which
translates to a lower COGS than the COGS recorded under LIFO. Hence, the net income using
the FIFO method increases over time.

LIFO
The latest goods added to the inventory are sold first. During periods of rising prices, goods with
higher costs are sold first, leading to a higher COGS amount. Over time, the net income tends to
decrease.

Average Cost Method

The average price of all the goods in stock, regardless of purchase date, is used to value the
goods sold. Taking the average product cost over a time period has a smoothing effect that
prevents COGS from being highly impacted by extreme costs of one or more acquisitions or
purchases.

Special Identification Method

The special identification method uses the specific cost of each unit if merchandise (also called
inventory or goods) to calculate the ending inventory and COGS for each period. In this method,
a business know precisely which item was sold and the exact cost. Further, this method is
typically used in industries that sell unique items like cars, real estate, and rare and precious
jewels.

Exclusions from COGS Deduction

Many service companies do not have any cost of goods sold at all. COGS is not addressed in any
detail in generally accepted accounting principles (GAAP), but COGS is defined as only the cost
of inventory items sold during a given period. Not only do service companies have no goods to
sell, but purely service companies also do not have inventories. If COGS is not listed on the
income statement, no deduction can be applied for those costs.

Examples of pure service companies include accounting firms, law offices, real estate appraisers,
business consultants, professional dancers, etc. Even though all of these industries have business
expenses and normally spend money to provide their services, they do not list COGS. Instead,
they have what is called "cost of services," which does not count towards a COGS deduction.

Cost of Revenue vs. COGS

Costs of revenue exist for ongoing contract services that can include raw materials, direct labor,
shipping costs, and commissions paid to sales employees. These items cannot be claimed as
COGS without a physically produced product to sell, however. The IRS website even lists some
examples of "personal service businesses" that do not calculate COGS on their income
statements. These include doctors, lawyers, carpenters, and painters.

Many service-based companies have some products to sell. For example, airlines and hotels are
primarily providers of services such as transport and lodging, respectively, yet they also sell
gifts, food, beverages, and other items. These items are definitely considered goods, and these
companies certainly have inventories of such goods. Both of these industries can list COGS on
their income statements and claim them for tax purposes.

Operating Expenses vs. COGS

Both operating expenses and cost of goods sold (COGS) are expenditures that companies incur

with running their business. However, the expenses are segregated on the income statement.
Unlike COGS, operating expenses (OPEX) are expenditures that are not directly tied to the
production of goods or services. Typically, SG&A (selling, general, and administrative
expenses) are included under operating expenses as a separate line item. SG&A expenses are
expenditures that are not directly tied to a product such as overhead costs. Examples of operating
expenses include the following:

 Rent
 Utilities
 Office supplies
 Legal costs
 Sales and marketing
 Payroll
 Insurance costs

Limitations of COGS
COGS can easily be manipulated by accountants or managers looking to cook the books. It can
be altered by:

 Allocating to inventory higher manufacturing overhead costs than those incurred

 Overstating discounts
 Overstating returns to suppliers
 Altering the amount of inventory in stock at the end of an accounting period
 Overvaluing inventory on hand
 Failing to write-off obsolete inventory

write-off definition The reduction or removal of an asset amount. For example, an account

receivable will be removed or written off if the customer is not able to pay the amount
owed to the company
How do you calculate cost of goods sold (COGS)?

Cost of goods sold (COGS) is calculated by adding up the various direct costs required to
generate a company’s revenues. Importantly, COGS is based only on the costs that
are directly utilized in producing that revenue, such as the company’s inventory or labor costs
that can be attributed to specific sales. By contrast, fixed costs such as managerial salaries, rent,
and utilities are not included in COGS. Inventory is a particularly important component of
COGS, and accounting rules permit several different approaches for how to include it in the
calculation.

Are salaries included in COGS?

COGS does not include salaries and other general and administrative expenses. However, certain
types of labor costs can be included in COGS, provided that they can be directly associated with
specific sales. For example, a company that uses contractors to generate revenues might pay
those contractors a commission based on the price charged to the customer. In that scenario, the
commission earned by the contractors might be included in the company’s COGS, since that
labor cost is directly connected to the revenues being generated.

How does inventory affect COGS?

In theory, COGS should include the cost of all inventory that was sold during the accounting
period. In practice, however, companies often don’t know exactly which units of inventory were
sold. Instead, they rely on accounting methods such as the “First In, First Out” (FIFO) and “Last
In, First Out” (LIFO) rules to estimate what value of inventory was actually sold in the period. If
the inventory value included in COGS is relatively high, then this will place downward pressure
on the company’s gross profit. For this reason, companies sometimes choose accounting methods
that will produce a lower COGS figure, in an attempt to boost their reported profitability.

Cost Classification

Definition: Cost classification is the logical process of categorizing the different costs involved
in a business process according to their type, nature, frequency and other features to fulfil
accounting objectives and facilitate economic analysis. Cost refers to the value sacrificed with
the aim of gaining something in return. Every business process involves some cost. It is the basis
of profit determination for an organization

Cost Classification in Relation to Cost Centre:

The elements of cost can be studied under the classification direct and indirect costs. If the object
of interest for identifying and measuring cost is to determine how much sacrifice is involved in
manufacturing a particular product, then initially one can define the three elements of total cost
i.e., materials, labour, and expenses.

i. Direct Costs:
The direct costs are those which can be identified easily and indisputably with a unit of operation
or costing unit or cost centre. Costs of direct material, direct labour and direct expenses can be
directly allocated or identified with a particular cost centres or a cost unit and can be directly
charged to such cost centre or cost unit. These costs are also called ‘traceable costs’.

ii. Direct Material:

The direct material costs are those which can be identified easily and indisputably with a unit of
operation or costing unit or cost centre. The direct material cost can be directly allocated or
identified with particular cost centres or cost units and can be directly charged to such cost
centres or cost units.

Raw materials are directly identifiable as part of the final product and are classified as direct
materials. For example, wood used in production of tables and chairs, steel bars used in steel
factory etc. are the direct materials that becomes part of the finished product.

iii. Direct Labour:

The labour cost incurred on the employees who are engaged directly in making the product, their
work can be identified clearly in the process of converting the raw materials into finished
product is called ‘direct labour cost’.

For example, wages paid to the workers engaged in machining department, fabrication
department, assembling department etc.
iv. Direct Expenses:
The direct expenses refer to expenses that are specifically incurred and charged for specific or
particular job, process, service, cost unit or cost center. These expenses are also called
‘chargeable expenses’.

Some of the examples of direct expenses include the following:

(1) Cost of drawings, designs and layout.

(2) Royalties payable on use of patents copyrights etc.

(3) Hire charges of special tools and equipment for a particular job or work.

(4) Architects, surveyors and other consultation fees of particular job or work.

Sometimes, if the direct expenses are negligible or small amount, it will be treated as overhead.

v. Indirect Costs:
Indirect costs cannot be allocated but which can be apportioned to cost centers or cost units.
These costs are also called as ‘common costs’. The indirect costs are not traceable to any plant,
department, operation or to any individual final product. All overhead costs are indirect costs.

Costs of indirect material, indirect labour and indirect expenses in aggregate constitute the
overhead costs and are the indirect component of the total cost. Indirect costs cannot be directly
allocated to cost units or cost centers and have to be absorbed or recovered into cost units.

vi. Indirect Material:

The costs incurred on materials used to further the manufacturing process, which cannot be
traced into the end product and the material required in the production process but not
necessarily built into the product are called ‘indirect material’.

For example, cutting oil used in cutting surface, threads and buttons used in stitching clothes,
lubricants used in maintenance of plant and machinery, cotton waste used in cleaning the
machinery etc. are considered as indirect materials.

Sometimes indirect materials like coal, fuel used in kilns etc. are considered as part of the prime
cost and some materials which are contained in small quantities in the end product like gums and
threads used in binding the books even though forming part of direct material cost, but is
considered not worth analyzing to cost units and may be categorized as indirect material cost.
vii. Indirect Labour:
The cost of indirect labour consist of all salaries and wages paid to the staff for the purpose of
carrying and tasks incidental to goods or services provided which will not form part of salaries
and wages paid in working directly upon the product.

For example, salaries and wages paid to store keepers, watch and ward, supervisors, timekeepers,
quality control, managers, clerical staff, salesmen etc. These indirect labour costs cannot be
identified with any particular job, process, cost unit or cost center.

viii. Indirect Expenses:

Indirect expenses are those which are incurred by the organization in carrying out their total
business activities and cannot be conveniently allocated to job, process, cost unit or cost center.
Rent, rates, taxes, insurance, lighting, telephone, postage and telegrams, depreciation etc. are the
examples of indirect expenses.

The concepts of direct and indirect costs are meaningless without identification of the relevant
cost unit or cost center. Segregation of costs into direct and indirect costs is essential for proper
accounting and control of costs and also for managerial decision making purpose.

Advanced manufacturing technologies such as Robotics, Computer Aided Design and

Manufacture, Flexible Manufacturing Systems, Optimized Production Technology, Just-in-Time
etc., are revolutionizing the manufacturing process at shop-floor, quality and creating areas for
improved opportunities. They have dramatically changed the manufacturing cost behaviour
patterns.

The direct cost component of product cost is decreasing while depreciation, engineering and
information processing costs are increasing. These changes have resulted in higher overhead
rates and a shrinking base of direct costs over which to allocate those costs.

Cost Classification for Decision Making:

For the managerial decision making the cost data can be analyzed keeping in view the
following cost concepts:
i. Marginal Cost:
The term ‘marginal cost’ is defined as the amount at any given volume of output by which
aggregate costs are changed if the volume of output is increased or decreased by one unit. It is a
variable cost of one unit of a product or a service i.e., a cost which would be avoided if that unit
was not produced or provided.
ii. Differential Cost:
It is also known as ‘incremental cost’. It is the difference in total cost that will arise from the
selection of one alternative to the other. It is an added cost of a change in the level of activity.

This concept is similar to the economists’ concept of marginal cost which is defined as the
additional cost incurred by producing one more unit of product. It refers to any kind of change
like add or drop a new product/existing product, changing distribution channels, add or drop
business segments, adding new machinery, sell or process further, accept or reject special orders
etc.

iii. Opportunity Cost:

It is the value of a benefit sacrificed in favour of an alternative course of action. It is the
maximum amount that could be obtained at any given point of time if a resource was sold or put
to the most valuable alternative use that would be practicable. Opportunity cost of good or
service is measured in terms of revenue which could have been earned by employing that good
or service in some other alternative uses.

Opportunity cost can be defined as the revenue forgone by not making the best alternative use.
Opportunity costs represent income foregone by rejecting alternatives. They are, therefore not
incorporated into formal accounting systems because they do not incorporate cash receipts or
outflows.

iv. Relevant Cost:

The relevant cost is a cost appropriate in aiding to make specific management decisions.
Business decisions involve planning for future and consideration of several alternative courses of
action. In this process the costs which are affected by the decisions are future costs. Such costs
are called relevant costs because they are pertinent to the decisions in hand.

The cost is said to be relevant if it helps the manager in taking a right decision in furtherance of
the company’s objectives. A relevant cost is a future cost which differs between alternatives. It
can also be defined as any cost which is affected by the decision at hand. The relevant cost must
be a future cost, i.e., one which is expected to be incurred and not a historic or sunk cost which
has already been incurred.

v. Sunk Cost:
The sunk cost is one for which the expenditure has taken place in the past. This cost is not
affected by a particular decision under consideration. Sunk costs are always results of decisions
taken in the past. This cannot be changed by any decision in future. The sunk costs are those
costs that have been invested in a project and which will not be recovered if the project is
terminated.

Amortization (the action or process of gradually writing off the initial cost of an asset) of past expenses, e.g.,
depreciation is a sunk cost. Sunk costs will remain the same irrespective of the alternative
selected. Thus, it need not be considered by the management in evaluating the alternatives as it is
common to all of them.

vi. Replacement Cost:

The replacement cost is a cost at which material identical to that is to be replaced could be
purchased at the date of valuation (as distinct from actual cost price at the date of purchase). The
replacement cost is a cost of replacing an asset at any given point of time either at present or in
the future (excluding any element attributable to improvement).

vii. Normal Cost:

The normal cost is normally incurred at a given level of output in the conditions in which that
level of output is achieved. Normal cost includes those items of cost which occur in the normal
situation of production process or in the normal environment of the business. The normal idle
time is to be included in the ascertainment of normal cost.

viii. Abnormal Cost:

It is an unusual or a typical cost whose occurrence is usually irregular and unexpected and due to
some abnormal situation of the production. Abnormal cost arises due to idle time for some heavy
break down or abnormal process loss. They are not considered in the cost of production for
decision making and charged to Profit and Loss Account.

ix. Avoidable Cost:

The avoidable costs are those costs which under given conditions of performance efficiency
should not have been incurred. Avoidable costs are logically associated with some activity or
situation and are ascertained by the difference of actual cost with the happening of the situation
and the normal cost.

When spoilage occurs in manufacture in excess of normal limit, the resulting cost of spoilage is
avoidable cost. Cost variances which are controllable may be termed as avoidable cost. These
costs are also called as ‘escapable costs’. The avoidable cost will not be incurred if an activity is
not undertaken or discontinued.
Avoidable cost will often correspond with variable costs. Avoidable cost can be identified with
an activity or sector of a business and which would be avoided if that activity or sector did not
exist. It refers to costs which can be reduced due to a contraction in the activities of a business
enterprise. It is the net effect on costs that is important, not just the costs directly avoidable by
the contraction.

x. Unavoidable Cost:

The unavoidable costs are ‘inescapable costs’ which are essentially to be incurred, within the
limits or norms provided for. It is the cost that must be incurred under a program of business
restriction. It is fixed in nature and inescapable.

xi. Pre-Production Cost:

The costs incurred prior to the starting of commercial production are called as ‘pre-production
costs’. These costs include preliminary expenses, trail run costs etc. These costs are incurred
from the initiation of project till its formal commercial production.

When a new factory is in the process of establishment or a new product line or product is taken-
up, a new project is undertaken, but the commercial operations have not started, during such
period all costs incurred are considered as pre-production costs and are treated as deferred
revenue expenditure except the costs which have been capitalized. Such deferred expenses are
charged to future production.

xii. Product Cost:

The product cost is aggregate of costs that are associated with a unit of product. Such costs may
or may not include an element of overheads depending upon the type of costing system in force –
absorption or direct. Product costs are related to goods produced or purchased for resale and are
initially identifiable as part of inventory.

These product or inventory costs become expenses in the form of cost of goods sold only when
the inventory is sold. Product cost is associated with unit of output. The costs of inputs in
forming the product viz., the direct material, direct labour, factory overhead constitute the
product costs.

xiii. Period Cost:

The period cost is a cost that tends to be unaffected by changes in level of activity during a given
period of time. Period cost is associated with a time period rather than manufacturing activity
and these costs are deducted as expenses during the current period without previously classified
as product costs. Selling and distribution costs are period costs and are deducted from the
revenue without their being regarded as part of the inventory cost.

xiv. Traceable Cost:

The traceable costs are those which can be identified easily and indisputably with a unit of
operation or costing unit or cost centre. Costs of direct material, direct labour and direct expenses
can be directly allocated or identified with particular cost centers or cost units and can be directly
charged to such cost centers or cost units.

xv. Common Cost:

The common costs cannot be allocated but which can be apportioned to cost centers or cost units.
The indirect costs are not traceable to any plant, department, operation or to any individual final
product. All overhead costs are indirect costs. Cost of indirect material, indirect labour and
indirect expenses in aggregate constitute the overhead costs and are the indirect component of
the total cost.

The concepts of direct and indirect costs are meaningless without identification of the relevant
cost unit or cost center. Segregation of costs into direct and indirect costs is essential for proper
accounting and control of costs and also for managerial decision making purpose.

xvi. Controllable Cost:

The controllable cost is a cost chargeable to a budget or cost center, which can be influenced by
the actions of the person in whom control of the center is vested. It is always not possible to
predetermine responsibility, because the reason for deviation from expected performance may
only become evident later.

For example, excessive scrap may arise from inadequate supervision or from latent defect in
purchased material. The controllable cost is a cost that can be influenced and regulated during a
given time span by the actions of a particular individual within an organization.

xvii. Uncontrollable Cost:

These costs cannot be influenced by the action of a specified member of the organization. The
controllability of cost depends upon the level of responsibility under consideration. Direct costs
are generally controllable by the shop level management. The uncontrollable cost is a cost that is
beyond the control (i.e., uninfluenced by actions) of a given individual during a given period of
time.
xviii. Short-Run Cost:
The short-run costs are costs that vary with output when fixed plant and capital equipment
remain the same and become relevant when a firm has to decide whether or not to produce more
in the immediate future.

xix. Long-Run Cost:

The long-run costs are those which vary with output when all input factors including plant and
equipment vary and become relevant when the firm has to decide whether to setup a new plant or
to expand the existing one.

xx. Past Cost:

The past costs are actual costs incurred in the past and are generally contained in the financial
accounts. These costs report past events and the time lag between event and its reporting makes
the information out of date and irrelevant for decision-making. These costs will just act as a
guide for future course of action.

xxi. Future Cost:

The future costs are costs expected to be incurred at a later date and are the only costs that matter
for managerial decisions because they are subject to management control. Future costs are
relevant for managerial decision making in cost control, profit projections, appraisal of capital
expenditure, introduction of new products, expansion programs and pricing etc.

xxii. Explicit Cost:

These costs are also called as ‘out of pocket costs’. The explicit cost is a cost that will necessitate
a corresponding outflow of cash. These costs involve cash outlay or payment to other parties.
Explicit costs are relevant in some decision making problems such as fluctuation of prices during
recession, make or buy decisions etc. These costs are recorded in the books of account and can
be easily measured.

xxiii. Implicit Cost:

These costs are also called as ‘imputed costs’ or ‘notional costs’. The implicit cost is a cost
which doesn’t involve actual cash outlay, which are used only for the purpose of decision
making and performance evaluation. Interest on capital is common type of implicit cost. No
actual payment of interest is made but the basic concept is that, had the funds been invested
elsewhere they would have earned interest.
Thus, implicit costs are a type of opportunity costs which cannot be recorded in the books of
account but are important for certain types of managerial decisions such as replacement of
equipment, evaluation of profitability of two alternative courses of action.

xxiv. Book Cost:

The book costs are those which do not require current cash payments. Depreciation, is a notional
cost in which no cash transaction is involved. Book costs can be converted into out of pocket
costs by selling the assets and having them on hire. Rent would then replace depreciation and
interest.

xxv. Shutdown Cost:

The shutdown costs are the costs incurred in relation to the temporary closing of a department /
division / enterprise. Such costs include those of closing, as well as, those of reopening. The
shutdown costs are defined as those costs which would be incurred in the event of suspension of
the plant operation and which would be saved if the operations are continued.

Examples of such costs are costs of sheltering the plant and equipment and construction of sheds
for storing exposed property. Further, additional expenses may have to be incurred when
operations are restored e.g., reemployment of workers may involve cost of recruitment and
training.

xxvi. Abandonment Cost:

The abandonment cost is the cost incurred in closing down a department or a division or in
withdrawing a product or ceasing to operate in a particular sales territory etc. The abandonment
costs are the cost of retiring altogether a plant from service. Abandonment arises when there is a
complete cessation of activities and creates a problem as to the disposal of assets.

xxvii. Urgent Cost:

The urgent costs are those which must be incurred in order to continue operations of the firm.
For example, cost of material and labour must be incurred if production is to take place.

xxviii. Postponable Cost:

The Postponable cost is that cost which can be shifted to the future with little or no effect on the
efficiency of current operations. These costs can be postponed at least for some time, e.g.,
maintenance relating to building and machinery.
xxix. Conversion Cost:
It is the cost incurred to convert raw materials into finished goods. It is the sum of direct wages,
direct expenses and manufacturing overheads.

How Are Period Costs and Product Costs Different?

Period costs and product costs are two categories of costs for a company that are incurred in
producing and selling their product or service. Below, we explain each and how they differ from
one another.

KEY TAKEAWAYS

 Product costs are those directly related to the production of a product or service intended
for sale.
 Period costs are all other indirect costs that are incurred in production.
 Overhead and sales & marketing expenses are common examples of period costs.

Product Costs
Product costs are the direct costs involved in producing a product. A manufacturer, for example,
would have product costs that include:

 Direct labor
 Raw materials
 Manufacturing supplies
 Overhead that is directly tied to the production facility such as electricity

For a retailer, the product costs would include the supplies purchased from a supplier and any
other costs involved in bringing their goods to market. In short, any costs incurred in the process
of acquiring or manufacturing a product are considered product costs.

Product costs are often treated as inventory and are referred to as inventoriable costs because

these costs are used to value the inventory. When products are sold, the product costs become
part of costs of goods sold as shown in the income statement. 

Period Costs
Period costs are all costs not included in product costs. Period costs are not directly tied to the
production process. Overhead or sales, general, and administrative (SG&A) costs are considered
period costs. SG&A includes costs of the corporate office, selling, marketing, and the overall
administration of company business.
Period costs are not assigned to one particular product or the cost of inventory like product costs.
Therefore, period costs are listed as an expense in the accounting period in which they occurred.
Other examples of period costs include marketing expenses, rent (not directly tied to a
production facility), office depreciation, and indirect labor. Also, interest expense on a
company's debt would be classified as a period cost.
What Is Forecasting?

Forecasting is a technique that uses historical data as inputs to make informed estimates that
are predictive in determining the direction of future trends. Businesses utilize forecasting to
determine how to allocate their budgets or plan for anticipated expenses for an upcoming period
of time. This is typically based on the projected demand for the goods and services offered.
What Is a Fixed Cost?

A fixed cost is a cost that does not change with an increase or decrease in the amount of goods or
services produced or sold. Fixed costs are expenses that have to be paid by a company,
independent of any specific business activities.
KEY TAKEAWAYS

 Cost structure management is an important part of business analysis that looks at the
effects of fixed and variable costs on a business overall.
 Fixed costs are set over a specified period of time and do not change with production
levels.
 Fixed costs can be direct or indirect expenses and therefore may influence profitability at
different points along the income statement.

What Is Depreciation?

Depreciation is an accounting method of allocating the cost of a tangible or physical asset over
its useful life or life expectancy. Depreciation represents how much of an asset's value has been
used up. Depreciating assets helps companies earn revenue from an asset while expensing a
portion of its cost each year the asset is in use. If not taken into account, it can greatly
affect profits.
Businesses can depreciate long-term assets for both tax and accounting purposes. For example,
companies can take a tax deduction for the cost of the asset, meaning it reduces taxable income.
However, the Internal Revenue Service (IRS) states that when depreciating assets, companies
must spread the cost out over time. The IRS also has rules for when companies can take a
deduction
KEY TAKEAWAYS

 Per the matching principle of accounting, depreciation ties the cost of using a tangible
asset with the benefit gained over its useful life.
 There are many types of depreciation, including straight-line and various forms of
accelerated depreciation.
  Accumulated depreciation refers to the sum of all depreciation recorded on an asset to a
specific date.
 The carrying value of an asset on the balance sheet is its historical cost minus all
accumulated depreciation.
 The carrying value of an asset after all depreciation has been taken is referred to as its
salvage value.

What Is Economic Order Quantity (EOQ)?

Economic order quantity (EOQ) is the ideal order quantity a company should purchase to
minimize inventory costs such as holding costs, shortage costs, and order costs. This production-
scheduling model was developed in 1913 by Ford W. Harris and has been refined over time. 1
The formula assumes that demand, ordering, and holding costs all remain constant.

KEY TAKEAWAYS

 The EOQ is a company's optimal order quantity that minimizes its total costs related to
ordering, receiving, and holding inventory.
 The EOQ formula is best applied in situations where demand, ordering, and holding costs
remain constant over time.
 One of the important limitations of the economic order quantity is that it assumes the
demand for the company’s products is constant over time.

What the Economic Order Quantity Can Tell You

The goal of the EOQ formula is to identify the optimal number of product units to order. If
achieved, a company can minimize its costs for buying, delivery, and storing units. The EOQ
formula can be modified to determine different production levels or order intervals, and
corporations with large supply chains and high variable costs use an algorithm in their computer
software to determine EOQ.

EOQ is an important cash flow tool. The formula can help a company control the amount of cash
tied up in the inventory balance. For many companies, inventory is its largest asset other than its
human resources, and these businesses must carry sufficient inventory to meet the needs of
customers. If EOQ can help minimize the level of inventory, the cash savings can be used for
some other business purpose or investment.

The EOQ formula determines a company's inventory reorder point. When inventory falls to a
certain level, the EOQ formula, if applied to business processes, triggers the need to place an
order for more units. By determining a reorder point, the business avoids running out of
inventory and can continue to fill customer orders. If the company runs out of inventory, there is
a shortage cost, which is the revenue lost because the company has insufficient inventory to fill
an order. An inventory shortage may also mean the company loses the customer or the client will
order less in the future.

Why is economic order quantity important?

Economic order quantity is important because it helps companies manage their inventory
efficiently. Without inventory management techniques such as this, companies will tend to hold
too much inventory during periods of low demand, while also holding too little inventory in
periods of high demand. Either problem creates missed opportunities for companies: too much
inventory generally means too little cash on hand, while not holding enough inventory will lead
to missed sales. For investors, calculating the economic order quantity for a company can help to
assess how efficiently that company is managing its inventory.

Reorder Level

In management accounting, reorder level (or reorder point) is the inventory level at which a
company would place a new order or start a new manufacturing run.

Reorder level depends on a company’s work-order lead time and its demand during that time and
whether the company maintain a safety stock. Work-order lead time is the time the company’s
suppliers take in manufacturing and delivering the ordered units.

Identifying the correct reorder level is important. If a company places a new order too soon, it
may receive the ordered units earlier than expected and it would have to bear additional carrying
costs in the form of warehousing rent, opportunity cost, etc. However, if the company places an
order too late, it would result in stock-out costs, for example lost sales, etc.

Formula

Reorder level depends on whether a safety stock is maintained.

If there is no safety stock, reorder level can be worked out using the following formula:

Reorder Level = Average Demand × Lead Time

Both demand and lead time must be in the same unit of time i.e. both should in in days or weeks,
etc.

If a company maintains a safety stock, reorder level calculation changes are follows:

Reorder Level = Average Demand × Lead Time + Safety Stock

Examples

Example 1: ABC Ltd. is a retailer of footwear. It sells 500 units of one of a famous brand daily.
Its supplier takes a week to deliver any ordered units.
The inventory manager should place an order before the inventories drop below 3,500 units (500
units of daily usage multiplied with 7 days of lead time) in order to avoid a stock-out.

Example 2: ABC Ltd. has decided to hold a safety stock equivalent to average usage of 5 days.
Calculate the reorder level.

Safety stock which ABC Ltd. has decided to hold equals 2,500 units (500 units of daily usage
multiplied by 5 days).

In this scenario, reorder level would be 6,000 units (2,500 of safety stock plus 3,500 units based
on 7 days of lead time).

What is Reorder Level?

Reorder level, also called the ‘reorder point,’ is the inventory level at which a company would
place a new order for a stock of raw materials for production. Theoretically, it was assumed that
there should not be a time gap between ordering and obtaining the raw materials. Thus, the
company can order new raw materials once the current stock level drops to zero and the suppliers
will instantly deliver the raw materials. However, it is practically almost impossible and
excessively costly to operate such a perfect procurement system. Thus, companies understand the
importance of maintaining a buffer (excess) stock and the new stock will be ordered once the
current inventory levels reach a predetermined level.

Reorder Quantity

Reorder quantity is the number of units that should be included in the new order. This is decided
upon finalizing the reorder level where the decision is made regarding how much of new
inventory should be ordered. It is equally important as deciding when to place the new order
since if sufficient quantity of raw materials is not ordered it will disrupt the production.

What is the difference between Reorder Level and Reorder Quantity?

Reorder Level vs Reorder Quantity

Reorder level is the inventory level at which a Reorder quantity is the number of units
company would place a new order for a batch that should be included in the new
of raw materials for production. order.

Nature

Reorder level decides when to order a new The number of units to be ordered is
stock of raw materials. decided based on the reorder quantity.

Calculation

Reorder level can be calculated as (Average Reorder quantity can be calculated as-
 daily usage rate x lead time in days). SQRT (2 × Quantity × Cost per Order /
Carrying Cost per Order).

Summary – Reorder Level & Reorder Quantity

The difference between reorder level and reorder quantity is that while reorder level signals the
company when to place a new order for raw material, reorder quantity demonstrates the size of
the respective order. Large scale companies who produces a number of products uses many
components, thus reorder level and reorder quantity will have to be calculated for each of the
different types of raw materials and orders should be placed with suppliers on time.

What is safety stock?

Definition of Safety Stock

Safety stock is an additional quantity of an item held by a company in inventory in order to
reduce the risk that the item will be out of stock. Safety stock acts as a buffer in case the sales of
an item are greater than planned and/or the company's supplier is unable to deliver additional
units at the expected time. If the company is a manufacturer, a safety stock of materials could
minimize the risk of production being disrupted.
Of course there are additional holding or carry costs associated with safety stock.
However, the holding costs could be less than the cost of not filing a customer's order on time or
having to stop its production line.

Example of Safety Stock

Assume that a company uses the economic order quantity (EOQ) model to determine the amount
of product or materials it orders. Since the model requires an assumption (estimate) of annual
demand, there is a risk that demand will be greater than the estimate used. Let's say that the
company's EOQ is 1,000 units. As a precaution, the company may decide to always have an
additional 100 units on hand as its safety stock. If demand is not constant, the company could
increase the quantity of its safety stock during its peak sales periods and then reduce the quantity
during periods of low sales.