For many companies, its largest cost is the cost of the goods it sells. This expense category is classified as “costs of goods sold” (COGS). Forecasting COGS is vital to financial models due to its tremendous impact on a firm’s profitability and cash flows. Because of its big impact on models, discounted cash flow models in particular, analysts must forecast COGS cautiously. In the paragraphs below, we discuss some of the best practices for modeling a company’s cost of goods sold schedule.
Breaking Down COGS by Business Line
Similarly to revenue, we advise analysts to break up a company’s COGS by business line. Doing so avoids grouping together a company’s multiple business lines which likely have varying costs and margins. To better understand why this is advisable, one must first understand what costs make up the “cost of goods sold” expense. For almost every business, there are several costs associated with the production and transportation of its products. These costs include but are not limited to materials, packaging, transportation, and insurance. Of course, depending on the product the company is selling it will have varying COGS. Furthermore, a company’s different product/business lines will have varying expenses. This is why breaking down COGS by business line is important when forecasting a company’s cash flows.
The importance of this concept is illustrated in our example as we broke down COGS into COGS for pants, shirts, and others. Because of the differing cost of the materials needed to make these products and other differing COGS, it would simply not make sense to group these together.
Breaking Down COGS by Categories
Also similar to how we broke down revenues, we also want to break down COGS by what it’s made up of – a mixture of fixed costs and variable costs a business takes on to fund the production and transportation of its products. So, we advise analysts to split a company’s COGS by grouping fixed costs and variable costs. This is because while variable costs will increase and decrease in accordance with sales volume, fixed costs will not. Therefore, trying to forecast them together would result in over or under-estimated cost forecasts in either group. Once we have separated a business’s different costs of goods sold into fixed and variable categories, we must forecast these costs over the coming years using an expected inflation rate and our previously calculated future sales volume. For variable costs, we advise analysts to forecast each individual cost for each business line on a per-unit basis and then convert it to total figures. For fixed costs, we advise analysts to do the opposite; forecast each individual cost in total figures and then convert these figures on a per-unit basis. To do so requires nothing but simple math using the equations shown in the example below. To view these simple equations, either right-click into individual cells or use the F2 command to view the formulas.
Alternatives to Breaking Down COGS by Categories & Individual Costs
While when applicable, we advise analysts to go the extra mile and break down COGS in their models, the information needed to do so is not always publicly available. This requires a company to report each individual cost that went into their “costs of goods sold”, this is seldom reported as the companies are only required to report a total COGS figure.
So, how should analysts navigate around this? We believe the best alternative to breaking down COGS is by forecasting annual gross profit margins. To do so analysts much predict a gross profit margin for each business line each year of their forecast period. Then, they can subtract these percentages from 1 to find the percent of revenue each business line spends on its costs of goods sold. This percentage multiplied by the business line’s forecasted revenue will give you forecasted COGS figures. This process can be seen in the example below under the “other” business line.
When it comes to forecasting gross profit margins, being off by even a few percentage points can have a tremendous impact on a company’s cash flows. This is why we strongly suggest analysts build several case scenarios if using the gross margin method for a significant portion of their COGS schedule. We also advise analysts to consider forecasted inflation rates, business-specific COGS, analyst forecasts, and management guidance when predicting these margins.