This article is part one of a three-part series on the cost of goods sold — a key metric that can help wineries understand their profit margins. In this article we provide an overview of how to calculate the cost of goods sold (COGS) and why it matters. In the second article we dive into steps for setting up a system and best practices to derive this metric, and in the final article we discuss specific COGS insights for wineries by case volume.
To evaluate your winery’s performance, it’s essential to have insight into its profit margins. Your winery’s profitability is driven by two things–what you can charge for your wine and what it costs to make and sell it.
The market generally determines what someone is willing to pay for your wine, so the cost of making and selling that wine largely determines how much profit is left over. The greater understanding and control you have over your costs, the greater your chance for running a profitable winery. This is why knowing what it costs to make your wine is so important.
While this might sound simple, there are many challenges associated with calculating the final cost of your wine. This includes determining what expenditures to include in production costs and how to allocate them as well as accurately tracking the costs and movement of your wine inventory throughout the winemaking process by varietal as well as by vintage and blend.
In this article, we’ll break down how to obtain the information you need to understand your profits and costs — including relevant accounting basics and strategies to categorize various production costs.
Accounting: The basics
In order to know your cost of goods sold (COGS) in a period you must first know what it cost you to produce those wines — this is referred to as the Cost of Goods Produced (COGP).
Here’s how they’re defined in the context of wineries:
COGP. Also known as wine in process (WIP), this encompasses all costs involved in the process of making wine. It includes the raw materials, services, labor and overhead — direct and indirect costs — costs incurred up to, and through the point of bottling the finished wine.
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The greater understanding and control you have over your costs, the greater your chance for running a profitable winery. This is why knowing what it costs to make your wine is so important.
Isolating the costing pools at various stages of production aids in allocating period overhead costs more precisely and allows for more accurate tracking of the component costs of blended wines. Grape costs may be recorded in a separate account initially, but these costs become part of the bulk wine inventory along with additional crush, fermentation, and cellar costs. The bulk wine cost with additional storage and overhead is combined with the cost of packaging materials used along with bottling labor to derive the individual unit cost of the finished wine.
Cost for inventory may use several methods to best match the production processes, including the following.
Specific identification (SPID)
Under this method, the cost of each inventory item is tracked from the time of purchase or production through the time the wine is bottled. It relies on accurate data input and recordkeeping to trace costs through the manufacturing process. This method calculates exact juice or wine yields for each vintage for each wine grape varietal — sometimes even by vineyard and vineyard block — and tracks the individual barrels used for each wine lot, parsing and combining as barrels are blended to their final form.
First-in first-out (FIFO)
This method assumes that items flow through inventory in the order they were purchased or produced. In other words, the oldest vintages are sold first. However, this is not always the case with wine.
Average cost
This method values inventory based on the average cost of all similar items available during the period. When costs aren’t easy to trace, it may be preferred to use an average, weighted average, or other ratio for applying costs. This method is also appropriate for consumable supplies, such as yeast and sulfur, or general costs, such as storage, utilities, and labor.
Last-in first-out (LIFO)
This method assumes the most recently purchased or produced inventory items are the first items to be sold. This is unrealistic for most wineries because wine is typically vintage-dated, with older vintages sold before newer ones.
In order for a winery to use LIFO for tax purposes, it is also required to use it for financial reporting purposes. Typically, wineries utilizing LIFO initially utilize SPID or FIFO for internal, managerial accounting purposes and record a LIFO reserve to adjust to LIFO for financial reporting and tax purposes.
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The process of applying overhead costs should evolve over time as operations become more complex, and so too should the allocation methodology — without negatively impacting consistency.
Shared expenses
Another costing challenge with overhead is categorizing expenses that are commonly shared between departments. Here are some examples of common overhead expenses of this kind and how they’re typically broken down.
Facilities and equipment. This category applies to the rent — or depreciation, if applicable — of shared facilities and equipment. Facilities can be split by square feet occupied by production, tasting room, marketing, and administration. Equipment may be used across functions and allocated on a reasonable and rational basis.
Utilities. Electricity and other utilities could be split based on estimated usage or through utility studies or dedicated usage meters. Many states offer additional tax credits for manufacturing activities. These typically require a utility study in which a third party performs tests to determine the average usage by manufacturing activities.
Wages. Some wineries choose to allocate a small percentages of wages paid to administrative employees for any work they performed in direct support of production activities.
When different departments share a similar facility or facilities, the overhead costs of running and maintaining the facility can be allocated based on the amount of space (square footage) each department uses. While there can be more accurate ways to associate specific overhead costs to the wine production, rent, utilities, and insurance are examples of expenses that can be allocated by looking at the utilization of space by the production and other departments. Of course, this approach assumes the facilities are relatively consistent in finishes, consumption of utilities, and drivers of insurance costs are similar for all departments. If circumstances exist such that they are dissimilar, then other methods should be used to make allocations.
Facilities example
A common method of allocating shared facility costs to functional departments is to capture such expenses in a cost center and allocate them based on the amount of space occupied by each department.
Take for instance a winery that has similarity and consistency across all departments and square footage allocation that reasonably reflects utilization derived by each department. If that winery has 10,000 total square feet and 6,000 is used for production, 60% of the facilities rent and facilities insurance costs could be allocated to wine production based on square footage. Utilities, on the other hand, should be allocated based on an estimate of usage. This methodology offers the benefit of being measurable and verifiable based on usage. If the production facility uses considerably more of the utilities than other portions of the facility, the allocation percentage can be adjusted.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.
COGS. This is the cost — COGP — previously incurred in making the specific wines that were subsequently sold during a given period, such as a month, quarter, or year. It’s important to note that, as the name implies, COGS only refers to the cost of wines sold during a given period — not the costs incurred in the process of making wine during that period.
Consistent with best practices, when a wine is sold, the cost of having made that specific wine is recorded as COGS, concurrently with recording the revenue from the sale of that wine. There can be other items that impact COGS specific to the accounting method used as well as other specific business cases that can be discussed further with your CPA. The difference between the revenue generated and the wine’s COGS is ultimately the gross profit on that wine.
Understanding gross profit margins
One of the first measures of gauging a winery’s profitability is its gross profit margin. You can calculate a winery’s gross profit margin in two steps:
Accounting methodology
When calculating the cost of making and selling wine, it’s typically recommended to use accounting principles generally accepted in the United States of America (U.S. GAAP). Usually, U.S. GAAP is the standard used for financial statements in business. From a management perspective, U.S. GAAP basis accounting is typically considered a more accurate reflection of a business' performance rather than tax basis accounting or another financial reporting framework.
Inventory methods
The elongated, often multi-year production process for making wine presents specific challenges in inventory costing because there can be significant time lag — often several years — between when the production costs are incurred and when the wine is sold and the associated production costs are recognized in the income statement as COGS. The long production process means wineries usually have multiple years or vintages of wine on hand in different stages of production.
For this reason, most wineries track and report their wine inventory costs in separate inventory pools such as bulk wine, packaging materials, and finished cased wine.
Choosing the method for your winery
SPID and FIFO costing are the most common methods used in a winemaking environment, especially because wine is typically vintage-based and tracked down to the individual wine stock-keeping unit (SKU).
As mentioned above, a significant number of wineries cost their wine using the SPID method for management purposes, then convert to LIFO for financial reporting and tax purposes. Changes to tax code in 2017 now allow expensing for many winemaking costs and therefore creating greater disparity between U.S. GAAP and tax-basis financial recordkeeping, so it’s useful to discuss this with your CPA.
Major cost categories
The Financial Accounting Standards Board (FASB) definition of inventory costs explicitly states that “determination of inventory costs involves many considerations.” These considerations include actual raw materials as well as other input costs and allocations of overhead costs directly related to the production of the inventory, such as labor, benefits, depreciation on production equipment, facility costs, and other shared costs of business operation that support production. The key phases of wine production are crush and ferment, cellar (and/or barrel) aging, and bottling. Each phase has unique processing activities and costs, and each activity is made up of at least three types of costs: direct materials, direct labor, and overhead. These are outlined below.
There are several ways to allocate costs, but regardless of the method used, it’s important to apply it consistently. Consistency is required by U.S. GAAP and it also makes it easier to spot variances when they do occur. Once a methodology is determined and adopted, a winery can fine-tune its data capture and reporting procedures to ensure the information used to cost its products are accurate.
Materials
Accounting for materials is typically straightforward in that the cost equals the price paid to acquire the materials, including tax and shipping costs to bring the materials to the production location.
Materials include the following:
Cost of grapes purchased or grown
Bulk wine purchases
Packaging materials, such as glass, corks, and capsules or screw caps, labels, and boxes
Note that packaging materials should be applied to the cost of finished goods inventory as used and may be specifically assigned to wines or allocated to all wines bottled in the period.
Labor
Labor is essential for turning materials into a finished product. This includes salaries and wages as well as related costs, such as benefits and payroll taxes, for employees involved in the following:
Grape production
Winemaking
Bottling
Maintaining production facilities
Owner, founder, and executive compensation is a difficult expense to classify because these individuals often work in many areas around the winery. Estimating the amount of their time spent with each department and applying the appropriate percentage of expense accordingly is a common approach.
Overhead
Classification of overhead costs can vary, depending on the size of the facility and whether there are shared uses of facilities by other revenue streams, such as facility rental or custom crush services.
Costs most often identified as overhead are those associated with running the production facilities assuming the facility is being run at normal capacity. These often include, but are not limited to, the following production and storage facilities and equipment related costs:
Rent or depreciation of production facilities and equipment
Insurance
Property taxes
Repairs and maintenance
Lab fees, general production and cleaning supplies, and services
Here’s an example of how facility costs might be allocated to different departments based on the square footage they use.
Allocating production costs
Production costs should be allocated to the various bulk wine in the cellar based on the type of processing activity and the stage of the wine in the process. Crush and ferment costs, which may include payroll, supplies, allocated overhead, and depreciation or rent related to crush equipment, should only be allocated to the current vintage crushed. On the other hand, cellar aging costs are typically shared by all wines in the cellar. These are most commonly allocated to the wines based on a weighted average number of gallons in the cellar. Barrel aging costs, which usually include barrel rent or depreciation, and sometimes an allocation of overhead, should only be allocated to the wines that are being stored in barrels, based on the weighted average gallons in barrels.
This method is often used in more basic costing models and for smaller wineries; however, it can still be used in more complex costing models of larger wineries.
When deciding which cost allocation method to use, keep in mind that no method will provide a perfect allocation. Consequently, it is best to use the simplest method available that provides an appropriate level of precision.
Using estimates
Finally, in the area of overhead, wineries will need to exercise judgment and use appropriate estimates. Wineries may choose to utilize other industry contacts or a CPA with wine industry experience to discuss the best approach for the situation. An outside entity can offer an unbiased perspective on missed costs and alternative ways to allocate the identified costs. The process of applying overhead costs should evolve over time as operations become more complex, and so too should the allocation methodology — without negatively impacting consistency. It’s also important that financial reporting disclosures provide transparency about inventory costing, methods, assumptions, and significant estimates.
Expenditure classification examples
The chart below lists expenditures that are commonly considered winemaking costs and some that aren’t. In some cases, certain expenditures may or may not be classified as winemaking costs; it really depends on the situation.
Pulling it all together
The charts below demonstrate how certain overhead and direct production costs might flow through the balance sheet and income statement.
*Crush and ferment may be its own cost center or may be a component of the cellar cost center. Allocation from facilities would follow the same methodology as the cellar allocations shown above.
Balance sheets and income statements
Once a winery has decided on a consistent protocol for classifying and tracking their winemaking costs and allocating overhead costs, those costs are accounted for and flow to the financial statements to reflect: one) the investment in wine inventory and; two) the relief of wine inventory through the sale of the resultant wines.
Example
The chart below includes financial data to demonstrate how certain overhead and direct production costs might flow through the balance sheet and income statement utilizing the following steps:
Facility costs being allocated to the cellar
Cellar costs being allocated to bulk wine inventory
Bulk wine inventory costs allocated to cost of bulk wine sold
Bulk wine inventory costs being allocated to bottled wine inventory
Bottled wine inventory costs being transferred to COGS for bottled wine sold
