This article is the final article a three-part series on the cost of goods sold—a key metric that can help wineries understand their profit margins. In our first article we provide an overview of how to calculate it and why it matters. In the second article, we outline steps for setting up a system and practices to derive these metrics. In this final article of the series, we provide COGS insights specific to wineries of different sizes.
With all the intricacies of bringing wine to market, accounting and finances typically aren’t a first priority. However, when wineries invest time and resources in these areas, they can derive valuable insights that may help increase profits.
This can be particularly for true smaller wineries, given how crowded and competitive the market is. A significant portion of US wineries produce under 1,000 cases annually. Many operate with limited resources and their owners typically play multiple roles within the company.
Here, we break down wineries by size, so you can see where you stand—and learn how to understand your cost of goods sold (COGS) and gain greater insight into how production and costs are impacting your bottom line.
Limited Production Wineries: Fewer than 1,000 Case Production
Limited production wineries—those producing fewer than 1,000 cases annually—accounted for 44% of US wineries in July 2019, according to Wines & Vines Analytics.
These winery owners are usually highly involved in most aspects of the business. Many, however, lack an accounting background and elect to outsource this area to a bookkeeper.
Small winery owners often choose to forgo the detailed, accounting principles generally accepted in the United States of America (U.S. GAAP) based-inventory costing COGS processes because their books are often kept on a tax basis. While this type of bookkeeping requires less rigorous reporting than what larger wineries typically adhere to, it often leaves wineries that choose this method lacking the very product cost information they need to make informed management decisions.
Even though calculating COGS on a U.S. GAAP basis isn’t always required for smaller wineries, it can be a condition for obtaining debt or equity financing from traditional sources, plus it provides other significant benefits. Through the process of capturing costs at the various stages of production and accurately tracking them in the accounting system, owners can gain valuable insight into how to improve their operational efficiency. These insights can provide a useful edge in a highly competitive market.
Winery owners can work with the winery’s internal accounting or the bookkeeper to understand production costs and how they impact cash balances and cash flow. Depending on growth plans or trajectory, the owner should have an understanding of what that growth means to the cost structure of the winery and the cash flow resources that will be required to fund that growth. Owners should decide who is responsible for evaluating costs and making purchasing decisions.
Very Small Wineries: 1,000–4,999 Case Production
Very small wineries, about 37% of the wineries in the United States, produce between 1,000 and 4,999 cases a year. In this range, the accounting responsibilities should include a focus on ensuring cost data is accurately and timely captured and properly classified to assist management in making informed business decisions.
This is most often the production level in which wineries begin to distribute wine, which introduces some challenges. At this stage, it becomes more critical that owners or management understand the cost structure of both the cost of production and the costs of distributing and selling wine through each sales channel–the direct-to-consumer (DTC) channel and the trade channel.
Changes in distribution and growth can affect the cost structure of the winery. Increasing production requires a winery to periodically incur significant investments in equipment and facilities to achieve necessary production capacity. These periodic investments in such fixed assets require careful cash flow planning and can increase the cost per case of production—at least until the production volume grows sufficiently to deliver greater economies of scale. Wineries should take into account how these additional fixed asset acquisitions will impact the depreciation expense, a production cost that will ultimately impact COGS.
Assuming that increased production decreases wine costs per unit is a common mistake. Many wineries use this theory to justify moving into trade distribution, and, while the assumption is often true if you can increase production with the same or minimal additional investment in production equipment, when it isn’t, the bottom line typically suffers. It all hinges on the winery’s cost structure–depending on what costs are fixed as opposed to variable. Wineries with a high variable cost structure will see costs increase in tandem with the growth in production. Conversely, wineries with higher fixed costs will achieve greater economy of scale as their production and sales volume increases and thus see their cost per unit decrease.
Before entering any distribution channel, owners should take the time to understand their costs and the potential gross profit associated with each distribution channel. This requires taking several factors into account.
Wine Production Costs
Understanding the full cost of producing a wine before it enters distribution channels is essential because it enables you to estimate the expected gross profit for a given wine, which can help you determine whether or not to make a wine, and, if so, how much of it to produce. It also figures into initial pricing strategies, which often drive early marketplace success.
Before investing money in distribution, first, develop a solid pricing strategy. To reduce the risk of over- or undercharging, consult with multiple distributors or distribution professionals on pricing strategies to help ensure your price points are appropriate for the brand and will stimulate sales while preserving profit margins.
Sales Channel Costs
It’s important to know the costs involved in selling wine in the DTC sales channel, such as tasting rooms and wine clubs, and in the trade sales channel, which includes sales to distributors, brokers, and trade accounts such as restaurants and wine shops. Researching these costs will also assist in making more accurate budgeting and revenue projections. To understand these costs, determine how much product will be sold in each channel and at what price(s). While your DTC gross profit margins are typically more attractive, the additional infrastructure and staffing required to sell DTC can offset the apparent benefits.
A financial model can be used to calculate the improvement in cost and the production volume to target before making decisions that will impact revenue. Wineries may consult with a CPA or financial advisor who specializes in wine production cost accounting and has relevant experience to determine if the model takes the appropriate potential variables into account.
Small Wineries: 5,000–50,000 Case Production
Wineries within this range of production are typically distributing product through multiple sales channels. They tend to have more staff and better processes and systems in place for costing and financial analysis. Practices and resources at this stage typically include the following:
- An accounting department
- A more sophisticated costing system
- A monthly review of key financial metrics
- Budgeting at the department level
Even if a winery has a dedicated accounting team, it can be useful for management to understand the following suggested best practices from a high level.
Generally Accepted Accounting Principles (U.S. GAAP)
If they haven’t already, wineries of this size should consider implementing U.S. GAAP basis accounting for: 1) internal accounting purposes; and 2) owning and controlling the process for activities, such as interactions with existing and potential future investors or debt covenant compliance. While U.S. GAAP is advised for all wineries, it becomes increasingly important at this stage because wineries are typically involved with more outside third parties who are likely to expect U.S. GAAP.
The accounting department should work with the production team to determine capital expenditures that could improve efficiency. This might, for example, involve determining when to do the following:
- Invest in larger capacity production equipment—such as tanks, presses, and pumps
- Increase storage capacity to keep up with growth
- Evaluate when it’s profitable to install bottling equipment rather than relying on a mobile bottler and their schedule and associated fees
Accounting should also monitor profitability on a monthly basis, investigate variances versus expectations, and provide management with forward looking financial forecast.
Accounting’s responsibilities should also include providing current product cost reporting to management and the sales department to enable informed pricing decisions. Ideally, they’ll assist the winery with developing a rolling five-year financial model to assist in estimating wine production costs, future revenue growth, and the required capital expenditures and labor cost structure needed to support that growth.
Accounting and ERP Systems
If they haven’t done so already, wineries of this size typically consider switching to an accounting system or enterprise resource planning (ERP) software with expanded capabilities, especially those that can integrate sales, production, inventory, and accounting activities. Generally speaking, before switching or adding systems, wineries should undertake a system needs assessment and analysis, ideally utilizing outside expertise, to make the most cost-effective decision. An ERP system would require all departments use the same system, so winery operators should verify that all departments agree upon the chosen system.
Before investing in a system, consider working with an advisor for guidance that can help you avoid common mistakes. An advisor familiar with multiple system selection processes and implementations can help wineries avoid common and often costly mistakes. Software vendors may understate potential difficulties in implementing their product while an independent advisor can provide valuable advice and support.
To learn more about ERP solutions, visit our Enterprise Systems Consulting page.
Medium Wineries: 50,000–499,999 Case Production
These wineries typically distribute to a majority of, if not all, 50 states and potentially internationally.
The accounting department should have a strong voice in the leadership of management and the company. Wineries in this category typically have both a strong CFO and controller, as well as a sizeable supporting accounting department. Generally speaking, medium-sized wineries account for COGS based on U.S. GAAP because the majority of them are required by their lenders or investors to provide U.S. GAAP financial statements reviewed or audited by an independent CPA.
Best practices noted in the smaller winery category are completed on a more regular basis, and management reviews the financial metrics of the winery monthly.
The accounting department for these wineries usually has a solid costing system in place and may consider using standard costing if their costs are stable and relatively predictable. If standard costing is used, these should be monitored regularly and adjusted as necessary to be in accordance with U.S. GAAP.
Production should calculate return on investment (ROI) for all capital expenditure requests. Wineries at this level of production usually actively manage cash balances and cash flow.
Budgeting by department is common and key metrics are used to manage the company. The accounting department typically plans ahead and forecasts financial results to facilitate better strategic planning. The winery should have a rolling five-year financial model to estimate future revenue growth and the capital expenditures and labor cost structure needed to along with the cash flow necessary to support that growth. The financial model is most effective when it models out product costs.
Insights for All: Tasting Room Activities
To better understand the profitability of the winery’s tasting room operations, wineries should account for tasting room activities as a sub-category within their selling expenses.
In general, wine should be transferred from the winery to the tasting room at cost, allowing margins to be calculated on tasting room sales independent from other sales channels. Tasting room inventory should be counted regularly as well as included in the winery’s physical inventory count.
Tasting rooms present some unique accounting challenges. Here are a few common challenges and some ways to help address them.
Improper accounting of product by staff, such as improper transfers from the winery and not charging or ringing in tastings, can contribute to inaccurate inventory records. To properly account for total COGS in the tasting room, wine must be transferred from the winery to the tasting room so that the tasting room tracks beginning inventory, consumed inventory, and ending inventory.
Sample losses should be reflective of this cost to the tasting room when they occur. Cellar losses impact gross margin on the winery side of the business while sample losses should be accounted for by the tasting room to reflect true tasting room costs and resulting gross margin.
Owner and Employee Sample Losses
As with sample losses discussed above, wineries should track and account for wine poured, free of charge, for owners and employees in the tasting room. Tracking these wine uses will help isolate sampling losses.
POS systems can account for owner or employee wines. For accurate results, all transactions should be entered into the system regardless of whether or not the wine is sold or provided free of charge. Under U.S. GAAP, revenue would not be recorded for employee wines if complimentary, however, the costs associated with these wines should be reflected in the income statement in a manner consistent with the respective employee’s compensation and may require being reported as compensation if other than de minimis.
It’s also necessary to know volumes sold and sampled for state and federal reporting requirements.
Accounting for tasting rooms also has its own intricacies. Here are the main steps to keep in mind:
- Set up selling expenses in their own categories separate from COGS. Tasting room wine revenue should be used strictly for sales through the tasting room. Set up additional revenue accounts as appropriate for merchandise or other categories of product sold through the tasting room.
- Designate selling expenses in the tasting room to include labor, including payroll taxes and benefit costs; as well as costs such as rent, utilities, cleaning, and supplies related to the tasting room.
- Identify metrics to measure the success of the tasting room and sales drivers.
- Implement controls where needed. Tasting room sales usually involve cash, which increases the risk of theft.
Audit Versus Review
As a winery grows and matures, it will likely eventually need the assistance of an independent CPA firm to provide some level of assurance on its financial statements. Owners and management teams often ask: Should we have an audit or review performed? The answer will depend on several factors.
When making a decision on what level of service you want an independent CPA firm to provide, you need to understand the level of assurance that comes with each type of engagement and the resulting report. This is critical to determining whether the service requested meets your needs as an organization and meets the expectations of the users of your financial statements—such as lenders, investors, or vendors—who most often drive these requests.
When considering an audit versus a review, the conversation amongst owners and management teams often leads to the cost differential. A review costs less than an audit and, as a result, is often viewed as the preferred option by the winery, especially for those with limited operating capital and tight cash flow. The downside is that a review provides only limited assurance and is substantially less in scope than an audit. A review doesn’t include obtaining an understanding of the business’s internal control system, assessing fraud risk, or testing of accounting records by obtaining audit evidence through inspection, observation, confirmation, or the examination of source documents.
An audit provides the highest level of assurance of all engagements performed in accordance with the standards established by the American Institute of Certified Public Accountants (AICPA). However, an audit doesn’t test all transactions, involves judgement and examination of evidence on a test basis and therefore the auditor’s opinion describes that an audit is planned and performed to obtain reasonable, but not absolute, assurance about whether the company’s financial statements are free from material misstatement. In an audit, the CPA firm is required to obtain an understanding of the entity’s internal controls and assess the risk of fraud. An audit includes examining evidence, on a test basis, supporting the amounts and disclosures included in the financial statements by obtaining audit evidence, using judgment and on a test basis, through inquiry, physical inspection, observation, third-party confirmation, examination, analytical procedures, and other procedures. However, because of the inherent limitations of an audit, together with the inherent limitations of internal control, an unavoidable risk exists that some material misstatements and noncompliance may not be detected, even though the audit is properly planned and performed in accordance with the applicable auditing standards. Also, an audit is not designed to detect immaterial misstatements or noncompliance with the provisions of laws or regulations that do not have a direct and material effect on the financial statements.
Often audits are required by lenders, creditors and outside investors that want the assurance level provided by an unmodified auditor’s opinion. Audits are also best practice prior to selling a company, as they can provide reasonable assurance that the financial information presented is free from materially misstatement and are more likely to result in reduced adjustments and questions in financial due diligence.
Choosing an audit or a review is mainly a question of your needs and the needs of your lenders, creditors, and investors. Cost should be considered, but it shouldn’t be the driving factor. Proper planning and discussions with your board of directors, investors, creditors, lenders, and a qualified independent CPA firm should yield the right decision for your company–one that will fulfill your needs in the most cost-effective manner.
Tax Return Considerations
Your tax preparer will likely also need to consider overhead when preparing the tax return for the winery, unless the winery meets certain qualifications and certain elections are made. Many tax preparers will prepare a separate inventory costing for tax purposes based on the tax laws which contain differences from U.S. GAAP, and will require certain records from you in order to do so.
A formal inventory valuation workbook completed at year-end can be used to report capitalized production costs, record correct inventory assets, and record COGS prior to tax prep. This can provide a helpful template of the annual production cycle for management and also for your tax team.
Some of these inventory items include tracking the following activities throughout the year:
- Bulk wine inventory movements
- Grapes purchased or grown
- Wines bottled and blended
- Bottled wine inventory movements (including: sales, samples, donations)
We’re Here to Help
If you have questions or would like any assistance with finding solutions tailored to your winery, please contact your Moss Adams professional.
For additional insights setting up and understanding the cost of goods sold for wineries, view the other articles in this series:
Seven Steps to Set Up a Cost of Goods Sold System for Your Winery
Accounting for the Cost of Making and Selling Wine
Special thanks to Andrue Ott, Outsourced Financial Accounting Specialist, for his contributions to this article.