Data is the key to successful corporate performance management. But how can the finance department ensure that the right financial data is available in the company and is used effectively?
The cost of sales method is an important component of a modern, multi-dimensional and data-based controlling and provides a focused assessment of costs and revenues, which forms the basis for effective reporting.
The cost of sales method is therefore of great importance for capital market-oriented companies and in the private equity environment, as it provides a detailed insight into the company's performance.
We are happy to share with you our experience on why many of our clients are switching to the cost of sales method and how to proceed with a conversion.
The cost of sales method (also referred to as "direct costing") is an income statement concept used to determine a company's expenses and profit exclusively based on the actual sales revenues generated.
Only those expenses that are directly related to the sales revenues generated in the period are deducted from the sales revenues. When presenting expenses, such as salaries, depreciation, etc., primarily functional areas such as general administration or sales are used instead of reporting the individual cost types.
The basic idea of the cost of sales method is to compare the sales revenues generated with the direct costs in order to create a type of contribution margin accounting. The contribution margin indicates the amount available after deduction of the manufacturing cost to cover the non production costs and ultimately the profit.
In Germany, both the total cost method (TCM) and the cost of sales method (COSM) are permissible methods for determining profit. Section 275 (1) to (3) of the German Commercial Code governs the applicability of both methods. The same applies in accordance with IAS 1.102 and IAS 1.103 in conjunction with IAS 1.104 for the determination of profits in accordance with International Financial Reporting Standards (IFRS).
In Germany, the total cost method is used much more frequently than the cost of sales method. If inventories of finished goods and work in progress are valued uniformly, the calculation of profit using the cost-of-sales method and the cost-of-sales method leads to an identical result.
However, the cost of sales method is much more widespread abroad and is used almost exclusively, particularly in the USA and some other English-speaking countries. In Europe, it is less common than the total cost method, but it is preferred in the UK and Ireland, for example. In other countries, such as France, it is even required by law.
Due to its better comparability and international acceptance, the cost of sales method regularly plays a major role in the preparation of financial statements in accordance with IFRS.
The nature of expense method provides for a classification of expenses and income in the income statement according to types of expenses and income (e.g. material and personnel costs). In this process, revenues are compared with all costs incurred in the production of goods and services in the respective period. If changes in inventories or own work capitalized occur during the period, an increase/decrease in inventories or own work is considered in the amount of the corresponding costs.
In the cost-of-sales method, operating expenses are broken down by functional area. The basic structure comprises at least the elements of sales revenue, cost of sales (of production), selling and administrative expenses and interest income / expense. Where relevant, research and development expenses are often reported as a separate functional area.
In each functional area, the cost elements of different departments or cost centers are combined. Production, purchasing and logistics, for example, are grouped together as cost of sales; sales, shipping logistics and marketing belong to sales expenses; finance, management, personnel, and IT to administrative expenses. As a result, the same cost types can be found in several places in the income statement.
In contrast to the total cost method, only the cost of sales incurred for the services sold is compared with the sales revenue. The cost-of-sales method therefore does not recognize changes in inventory. For example, if products manufactured in a previous period are sold, the cost of sales recognized to generate this revenue includes the manufacturing costs incurred in the previous period.
The reasons for switching to cost of sales accounting can vary greatly.
Most of our projects involve companies that are moving in the direction of the capital market and thus have to meet increased accounting requirements. Then there are companies that require a higher degree of transparency and comparability due to internationalization or the entry of international investors.
A conversion to the cost-of-sales method can be advantageous for various strategic reasons:
In some cases, strategic decisions almost inevitably lead to a conversion to the cost-of-sales method:
As the cost of sales method focuses more on the collection of data and information, it is rated much more innovative. In contrast to the total cost method, the cost of sales method relies on a stronger link between costs and sales and product revenues. It requires the actual revenues and costs per product or service to be determined, thus enabling a more differentiated analysis of the profitability of individual products or services, more profound decisions and a more detailed analysis of business processes.
The cost-of-sales method is thus a component of modern controlling and can help to sustainably improve performance in the company.
When converting from the nature of expense method to the cost of sales method, we first distinguish between retrograde and prospective conversion.
In the case of a retrograde conversion, historical data is converted to the cost-of-sales method. In such a case, the conversion is usually not performed in the operational financial accounting or ERP systems, but outside based on simplifying assumptions and allocations. A retrograde conversion may be necessary if an income statement for historical periods is required using the cost of sales method due to regulatory requirements or in the case of a planned IPO. In addition, a retrograde conversion may be useful if prior-year figures are required as comparative data for future periods.
In the case of a prospective conversion, the cost of sales method is only applied from the time of the changeover and for future periods. This means that the conversion is carried out directly in the underlying financial accounting or ERP systems and is carried out according to structures and costs that are largely based on causation. In some modern systems, even a parallel presentation according to total cost and cost of sales methods is possible.
In direct connection with the time-oriented distinction is also the distinction according to the conversion level.
The choice of the conversion level that makes sense in a specific case depends on criteria such as the amount of work involved, the degree of integration between accounting and controlling, the desired reliability of the information, as well as the conversion effort and time pressure.
In addition to the direct effects of converting to cost-of-sales accounting, additional side-effects must be considered:
A conversion to the cost of sales method is a multidimensional project for which it requires profound knowledge and experience in the areas of accounting, financial accounting, controlling and cost accounting as well as the application and possibilities with ERP systems.
In addition, a conversion to cost of sales accounting also has side effects on topics such as processes, controlling and incentives, for which a comprehensive understanding of the CFO area is important.
With our experience and combined professional as well as technical-process expertise along the CFO agenda, PAS Financial Advisory AG is the perfect partner for a planned changeover from total cost accounting to cost of sales accounting.
We are happy to report on our experience with successful cost-of-sales conversions.