Cost of sales

The power of data: How the cost of sales method forms the foundation for effective reporting

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.

What is the cost of sales method?

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.

What are the differences between the nature of expense method and the cost of sales method?

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.

What are the reasons for a conversion to cost of sales accounting?

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:

  • Simplified cost structures: Since the cost-of-sales method compares only the direct cost of sales with the revenue, the income statement is more informative.
  • Optimized management: The cost-of-sales method provides valuable information on the actual costs and the contribution margin of products or services in the income statement. As a result, better decisions can be made on the basis of sound data.
  • Increased efficiency: The greater transparency in the cost structure and more targeted analysis can lead to a change in thinking throughout the company so that potential for cost reduction is identified earlier, which can lead to an overall increase in efficiency and potential competitive advantages.
  • Greater comparability: The cost of sales method enables better comparability of companies and industries by simplifying the cost structure and making the income statement more meaningful. As a result, companies can be better compared with each other.
  • More effective planning: Since the cost-of-sales method only records direct production costs, it is easier to plan costs. This facilitates cost control and enables more effective planning.

In some cases, strategic decisions almost inevitably lead to a conversion to the cost-of-sales method:

  • Internationalization: if a company is planning to internationalize, it may be advantageous to switch to the cost-of-sales method, as this is the only way to ensure comparability with competitors. In addition, it is likely that international business partners or financiers will demand an income statement according to the cost of sales method for comparison purpose
  • Compliance: In some countries, the cost of sales method is required by law, i.e. the commencement of business activities in these countries may necessitate a conversion
  • International Financial Reporting Standards: In the case of a decision to convert accounting to IFRS, it may make sense to convert the income statement to the cost-of-sales method.
  • IPO: Since a high level of transparency of company data is required for an IPO, the cost of sales method may be necessary to increase investor confidence

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.

What is the approach for a changeover to the cost of sales method?

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.

a) A conversion at the reporting level involves an implementation in reporting, i.e. a conversion is usually not carried out in the operative financial accounting and ERP systems, but outside in a corporate performance management system (e.g. LucaNet) or in Excel. With this conversion method, the nature of expense method remains as the basic classification scheme of the chart of accounts. Finance processes and procedures, IT systems and interfaces remain largely unchanged. The logic for the conversion to the cost-of-sales method is based on a reconciliation matrix, which consists of a combination of cost elements and cost centers and thus enables a transformation to the COSM schema.

The advantage of this conversion method is that it is faster and more cost effective. The disadvantage is that the data may not be complete or accurate enough, and that detailed evaluation of the data using the cost-of-sales method is not possible in the upstream systems, and at the detailed evaluation level of COSM data is usually only available in an aggregated form.

b) A conversion at the recording level requires the implementation of the cost of sales method in accounting. In this case, all costs are recorded or derived and posted on a function-related basis when they are entered.

Example: Determination options for functional areas in S/4HANA

  • Derivation from master data (G/L accounts, cost centers, orders, etc.)
  • FI substitution (validation rules)
  • Manual entry

A conversion at the data entry level requires changes in the financial accounting or ERP systems, the data structures, the chart of accounts, and the related documentation, workflows, and organizational structures.

The advantage of a conversion at the data entry level is that the accounting data is available from the outset in a form suitable for the cost of sales method, which increases the possibilities for evaluation and reporting and reduces the effort required. The disadvantage is that extensive changes to the accounting processes and IT systems are necessary for a conversion at the entry level, which can be associated with considerable effort and costs. In addition, this conversion method requires appropriate training and familiarization in the finance team.

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: 

  • Financial ratios: The use of the cost-of-sales method can lead to changes in the company's financial ratios.
  • Corporate culture: A switch to cost of sales accounting can lead to greater cost and margin awareness and a change in corporate culture.
  • Planning: Since profit determination changes because of the conversion to cost-of-sales accounting, planning processes must also be adjusted accordingly.
  • Comparative figures: A conversion to the cost-of-sales method requires an adjustment of historical comparative figures. 
  • Incentives: If variable compensation components are based on key profit figures, the incentive systems must be adjusted accordingly. 
  • Reporting: A conversion to the cost-of-sales method requires adjustments to the BI and reporting systems, as key figures and reports have to be redefined and structured. 

PAS - Perfect Match for the conversion to cost of sales accounting!

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 GmbH 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.

If you have any questions, please contact our specialists at any time!
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Fabian Formanek
Manager - Finance Optimization
PAS Financial Advisory GmbH