Cost of Goods Sold (or COGS as it is more commonly referred to) is one of the most important metrics for an e-commerce business. It is interconnected to almost every aspect of an e-commerce business. You base your pricing decisions, inventory decisions, marketing strategy, cash flow management, and tax calculations among other critical business functions on COGS. Therefore, miscalculating COGS can negatively affect your business and have serious implications.
Accurately calculating COGS helps you price your products strategically and get a better understanding of your top-line profitability. It also helps you prepare effective marketing strategies based on your profit margins.
After all, you need to know precisely how much you spend on products you sell to ascertain how much to price them and how much money you are actually making out of it.
Having said that, calculating COGS can often be challenging for e-commerce businesses. According to Small Business Report Accounting, 60% of small business owners acknowledge that they might not have sufficient knowledge about accounting and finance. Looking at the percentage, it is wise to understand how COGS can impact your accounting and sales.
Our exhaustive guide will help you understand what is the cost of goods sold, how to accurately calculate the cost of goods sold, and why does cost of goods sold matters to your e-commerce business.
So let us get started!
What is the Cost of Goods Sold (COGS)
The cost of goods sold is the total cost of selling products. In simple words, you can understand it as the cost incurred by retail businesses including e-commerce businesses to produce or acquire the products they sell. It includes not just the cost of the product itself, but every production, material, and labor expense associated with the product also forms part of the cost of goods sold.
When an e-commerce business manufactures its own products, the cost of goods sold is equal to the expense directly incurred in producing the products, like the cost of raw materials, labor, etc.
On the other hand, when an e-commerce business procures inventory from a third party, the cost of goods sold is equal to the expense associated with acquiring that inventory.
Let us understand what’s included in COGS and what’s not.
What is Included in COGS and What is Excluded
Getting the COGS number right is crucial for any business. It is essential for a variety of metrics key to e-commerce businesses especially in knowing the gross margin.
COGS Includes
- Cost of the product – It is the cost you pay to your vendors and suppliers for the products you sell i.e. raw materials cost, direct labor cost, manufacturing cost, etc. associated with the said product.
- Freight in – It is the cost you pay to get the product to your warehouse.
- Duties and fees – Any other cost incurred to get the product to your warehouse.
COGS Excludes
- Freight out – It is the cost you pay to ship the product to your customers.
- Tooling fees – It is the cost incurred for tooling.
- Research and Development – It is the cost incurred on the research and development of the product before you sell it.
- Indirect costs – It is the cost incurred on selling the product such as marketing cost, shipping cost, overheads, and other operating expenses.
How to Calculate Cost of Goods Sold for E-commerce Business
COGS is calculated using the following accounting formula:
Cost of Goods Sold = Starting Inventory + Purchases Made During Period – Ending Inventory
In the above formula,
– Starting inventory stands for the total value of inventory remaining from the previous period.
– Purchases made during the period stands for the total cost of inventory/products purchased or manufactured during the reporting period taking into account freight and other direct costs.
– Ending Inventory stands for the value of unsold inventory left at the end of the reporting period.
Example of Cost of Goods Sold for E-commerce Business
Assume an e-commerce business had a starting inventory of $150,000. During the year, they purchased another $200,000 worth of inventory. They ended up with $100,000 leftover inventory. In this case, the e-commerce business’s COGS would be calculated as follows:
COGS = $150,000 + $200,000 – $100,000 = $250,000
Accounting Methods for Calculating COGS
The value of COGS depends on the inventory valuation method chosen by a business. Different inventory valuation methods yield different inventory values, and they can have a significant impact on COGS and profitability. Therefore, before you calculate the cost of goods sold, you need to figure out which accounting method would you apply to calculate COGS.
There are four common methods for calculating COGS for your e-commerce business.
- The First-In, First-Out (FIFO) Method
In the FIFO method, the goods produced or purchased first are sold first. Hence, the cost of products that were produced or purchased first from suppliers would be considered for calculating COGS. The FIFO method is ideal for products that have a short shelf life and are perishables.
- The Last-In, First-Out (LIFO) Method
LIFO is the opposite of FIFO. In the LIFO method, the goods produced or purchased last are sold first. Hence, the cost of products that were produced or purchased last from suppliers would be considered for calculating COGS. The LIFO method is best suitable for companies during times of inflation as it helps them save on taxes and match their revenue to their latest costs when prices are rising.
- The Weighted Average Method
In the weighted average method, the average price of all products in stock is considered to value of the goods sold. Unlike other methods, the weighted average method considers inventory as a pool and does not take into consideration which units are sold first. In this method, the costs are weighted by the number of units. The weighted average method is best suitable for mass-produced items such as water bottles, off-the-rack clothing, or interchangeable items.
- The Specific Identification Method
The specific identification method is used to track each individual purchase and its corresponding price. This method is ideal for high-value or customized products to match the actual costs to the specific items in inventory.
Let us understand the above four methods with the help of an example.
Example to Understand the Inventory Valuation Methods
Let’s say, an e-commerce business sells soaps and the first 5 soaps that they purchase from their supplier cost them $2 each. Due to increased raw material costs, the next 2 soaps they purchase cost them $2.50. During the next period, they sell 4 soaps.
If we use the FIFO method, the COGS of the e-commerce business would be $8 ($2 x 4 = $8).
If we use the LIFO method, the COGS of the e-commerce business would be $9 [($2.50 x 2) + ($2 x 2)].
If we use weighted average method, the COGS of the e-commerce business would be $8.50 [($15/7) x 4].
If we use a specific identification method, the COGS of the e-commerce business would depend on the individual item sold.
What Does COGS in Income Statement Reflect, and Why is it Important?
Knowing the accurate COGS is crucial to a variety of metrics key to e-commerce businesses.
First of all, COGS is an important determinant of gross profit as gross profit is calculated by subtracting COGS from revenue. Gross profit is a critical key performance indicator that reveals the core essence of business viability and an important parameter used by investors, lenders, and managers to gauge the efficiency of a company’s production processes.
COGS calculation reflects the correct cost of manufacturing or procuring the products sold. It helps in setting the right customer pricing to yield an adequate profit margin.
Calculating COGS on a product, SKU, or category level will help you determine product profitability. Based on COGS, you can frame your pricing strategy, marketing strategy, purchasing strategy, and much more.
Cost of Goods Sold and Accounting Software
Calculating the cost of goods sold can often be challenging for businesses especially when the volumes are high and there are too many product lines. A robust accounting software like NetSuite can reduce the effort required and ensure accuracy.
How Can Ledger Labs Help?
Ledger Labs specializes in NetSuite Accounting Services for small to midsize businesses. The cloud-based accounting tool can help you analyze accurate gross margins, access true profitability, optimize marketing strategy and price your products strategically.
With a decade-long experience in helping multiple e-commerce businesses, we can find out effective ways to manage and evaluate the cost of the inventory or the cost of goods sold accurately.
Our team of highly skilled professionals can assist you in implementing systems and configuring them with a workflow that works for your team.
Get in touch with us now!
