E-commerce trade typically sees the cost of goods sold or COGS in their income statement. For product-based businesses, it’s indispensable to recognize, track and manage your COGS. As your catalog grows and becomes more intricate, so does keeping track of COGS. Let’s dive into COGS and how you can accurately calculate it efficiently using accounting methods. Later there must be automatic sync of COGS to your accounting software. Finally, we go through strategies for keeping accurate numbers across all your systems and ways for reducing COGS.
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Concept of COGS:
Calculating the Cost of Goods Sold (COGS) is thought-provoking for any eCommerce business. It’s more complex than the cost you pay your vendors per unit. In addition, calculating that number is yet another more significant challenge.
What’s included in cogs, and what isn’t
The first area to think about is calculating your inventory cost and, subsequently, COGS correctly. Knowing what fees should be included in your product cost (Inventory on the balance sheet) will finally hit COGS on your income statement as you sell it. Getting this number right is critical in knowing your gross margin, which is essential to any business. Many businesses fail because their margins need to be higher.
Included:
- Cost of the product: the cost you pay your vendor for the products you sell.
- Freight in: how much did it cost to get the product to your warehouse?
- Duties and fees: any other costs incurred to get the product to you.
Excluded:
- Freight out: costs you pay to ship the product to your customers.
- Tooling fees: costs incurred for tooling.
- R&D: costs incurred to research and develop the product before you are ready for sale.
Why is it essential to understand COGS?
COGS give your insight into the health of your business. Most remarkably, COGS lets you calculate your gross profit and gross profit margin.
Gross Margin = Revenue – COGS
Revenue-Cogs / Revenue X 100 = Gross Profit Margin
If these numbers are too low, you won’t have sufficient money for functioning expenses. Your company won’t be in a profit. You can enhance your margins by increasing your prices or lowering your COGS.
Despite the reputation of the cost of goods sold for e-commerce stores, many store owners need more visibility to make all-inclusive decisions using COGS. For instance, Shopify and WooCommerce do not offer total cost of goods sold data, while Magento’s out-of-the-box reporting product does not immediately make COGS available.
Accurate COGS data helps businesses price their products tactically and understand their top-line productivity. You need to know how much you apply to the products you sell to understand what to price them at and how much money you’re transporting. Understanding the cost of goods sold also helps stores strategies how to best market products based on profit margin.
In addition to marketing strategy deliberations, stores can use the cost of goods sold to price products more professionally so that a margin is available to pay for operating expenses related to maintaining and scaling their business. These operating expenses include web hosting fees, development expenses, and office space maintenance.
What are the three steps to calculating the Cost of Goods Sold?
1. Know your Inventory well.
To figure out your COGS, you’ll need inventory quantities. For the period you’re looking at:
- How much Inventory did you start with? It is referred to as the Beginning or starting Inventory.
- How much Inventory have you purchased during a given period? This is referred to as your purchases Inventory.
- How much Inventory do you have at the end? This is your Ending or Inventory.
Your inventory management software should identify this for you. But verifying the numbers on your books with a physical inventory count is significant. An inventory count is a physically counted Inventory with you at the end on hand. This comprises Inventory at all stages of production, including raw materials. It would be best if you carried out these checks quarterly.
2. Know the cost of your merchandise.
Once you have your proper quantities, it’s time to work out the price of the merchandise item. Below are four ways to know about the Inventory.
First in, first out (FIFO)
First in, first out means that the oldest item you bought is the first one you sell. FIFO is the way most business work with Inventory.
Last in, first out (LIFO)
Last in, first out means that the newest item you bought is what you sell first. Some nations do not allow the use of LIFO, so consult an accounting professional before choosing a method.
Average Cost Method (ACM)
The average Cost Method takes the total cost of your Inventory and splits it by the number of items bought. The average price is applied to all your Inventory. This method is less precise than other methods but is simple and reliable. This makes it well-suited for smaller businesses.
Specific Identification
The Specific Identification method values each item distinctively. This method is very accurate, but it’s labor-intensive. It’s mainly suited to sellers who produce a small number of unique or high-cost items.
3. Use the formula based on Inventory for COGS.
(Beginning Inventory) + (Purchases) – (Ending Inventory) = COGS
There are two significant challenges that e-commerce businesses face with COGS accounting.
1. Cash/accrual accounting and COGS
Your accounting way affects how and where COGS shows up on your financial statements. Cash accounting might twist your data; Inventory always upholds your balance sheet. You don’t recognize it as an asset. Instead, Inventory goes straight onto your income statement as an expense when you buy it. You’ve had a bad month, repeated for several amazing months. There’s no direct connection between your COGS and your revenue.
Accrual accounting is the right fit. Accrual accounting produces a relationship between COGS and revenue. Inventory is put as an asset on your balance sheet when you have it. As Inventory is sold, the cost of that Inventory is placed in the balance sheet as a COGS expense. This distributes your COGS properly across the whole year. And COGS makes up the same percentage of your sales every month. You’ll have a more accurate view of your business’s performance.
2. COGS and inventory management
Every industry has accounting difficulties, and e-commerce quickly leads the charge regarding bookkeeping challenges, which can often be much more complicated than other industries. The COGS is one of the essential aspects of accounting. It considers all the direct costs involved in selling products to launch the actual cost of doing business as an e-commerce retailer. Understanding the COGS gives retailers a more vital understanding of their profits and how to manage their cash flow. It also directly affects accounting management and tax calculations.
Direct costs involved in e-commerce inventory can include raw materials and manufacturing costs, packaging, and shipping costs. Simply estimating the COGS can have disturbing effects on the books of e-commerce traders. Similar to the miscalculation of COGS is the challenge of correctly understanding the Inventory on hand and how to account for it. Knowing how much Inventory your business has on hand can be challenging when taking into account the amount of stock in production vs the number in a shopping cart, on its way to clients, or making its way back to your warehouses as returns. It is common for e-commerce retailers to have unaccounted-for cash worth of Inventory.
Yet, knowing the inventory numbers significantly affects your accounting. This is why it is of the highest importance that e-commerce businesses get the correct inventory management software setup, as the accounting matching principle requires that revenues and related expenses be recognized together in the same reporting period, which might become challenging when considering the inventory challenges outlined above.
Importance of Knowing COGS
1. Set the right product price.
Knowing your COGS allows you to set up the accurate product cost without deterring your customers. You can successfully cover your business’s operating costs with the right price while earning a healthy profit margin. Generally, you will be in an excellent position to know when you require to reduce or increase your product prices. Of course, you can use COG and other industry-approved methods to ensure that you effectively compete with other businesses in the same niche.
2. Manage Your Taxes
There is a direct relation combination between your COGS and your taxes. Be aware that sold COGS for your business are tax-deductible. COGS are usually the second line item in companies’ income statements. You want to avoid legal problems for not properly putting your taxes.
If your company has high COGS, you will spend fewer taxes with a lower net income. This will also be a key highlight in warning you that your business is likely not making enough profit; hence, you need to devise a system that creates a healthy balance between your business’s profitability and operational costs.
3. Detect Growth Opportunities
Reliably using COGS means using the past data attained to determine seasonal trends. By using old changes, you can identify new opportunities that will drive the growth of your business. For instance, if your COGS are higher in winter, you can expand your business with products in demand in winter to minimize the risk of losses.
4. Analyse Your Business’s Health
You can conveniently use COGS to calculate different ratios to determine your business’s health. As a result, you can make better decisions, particularly those more likely to impact your business positively. Moreover, the obtained information can help you determine if your company should try and reduce operational costs, if you can fully pay your debts, or if you should consider closing down your business.
If you are an eCommerce business looking to unlock remarkable data-driven growth, consider using REVEAL. This software program can organically increase the number of customers loyal to your business. Additionally, it provides actionable insights on how you can maximize profits and assist in enhancing customer lifetime value.
5. You can reduce COGS and increase margins.
If your goal is to reduce your e-commerce business’s COGS, there are several ways to go about it. Reducing COGS can make more sense than increasing prices, depending on your circumstances. We’ll go through a few critical strategies; however, please note that not all of these will be relevant to you.
- Take advantage of economies of scale where possible.
- Change suppliers, materials, or manufacturers entirely. If negotiating with the businesses you’re currently working with based on economies of scale is working, it’s worth looking at alternatives. This could mean going for a supplier with cheaper shipping, lower-cost material for your manufacturing, or offshore manufacturing.
- Look at the products that aren’t selling. Even if these products have significant margins, they’ll negatively impact your COGS if they sit on the shelves.
- Eliminate bottlenecks and errors in your supply chain. For instance, materials being damaged, goods being lost with your current shipping process, or inefficiencies with labor.
- Automate as many workflows as possible. As an accounting automation solution, we must remember the importance of automation. Automation can make a massive difference if labor costs make up a large part of your COGS.
Conclusion
Ensure you continue to verify that the flow is working as manual and automated processes can yield errors, either by manual data entry or broken integration between apps. To achieve long-term success as an eCommerce company, you must calculate your inventory costs accordingly. It’s essential to keep detailed records of all sales and expenses to determine the COGS. If you need help, bring an expert in implementing systems and configuring them with a workflow that works for your business. Integrated COGS data helps e-commerce stores understand their true profitability, optimize marketing strategy and advertising spending relative to product profitability and move away from a more general approach to product marketing.
