Bright-eyed entrepreneurs usually aren’t interested in accounting. They don’t revel in pouring over balance sheets and income statements. They’re visionaries, and these details don’t do much for their leadership, innovation, and creativity.
Unfortunately, most owner-operators of eCommerce businesses don’t have a choice. They must wear multiple hats — one of them being that of “accountant.”
Many small businesses fail because of a lack of attention to profit margins. They assume that just because they’re selling something for less than they’re buying it, they’ll continue to scale. That’s only a tiny part of the whole accounting puzzle. This is where the cost of goods sold (COGS) comes in.
Calculating your COGS is essential for discerning your net profit (your bottom line number). You don’t need to be an accountant to do it, though. You just need some reliable data and a calculator.
In this post, we’ll review:
- What COGS is and which costs make up it
- Multiple techniques for calculating COGS in an eCommerce context
- How to use COGS to find net profit
What is COGS?
The cost of goods sold is a fundamental accounting metric found on most businesses’ balance sheet or cash flow statement.
It is a representation of the total costs incurred by selling products over a given time.
Download a cash flow statement from any publicly traded company, and nine times out of ten, you’ll see Cost of Goods Sold (or sometimes Cost of Product) as a line item.
COGS is more than inventory cost, but not less (as we’ll review in the next section).
So why should we care about this? Because finding COGS is an essential step in discerning your margins as well as your net profit. Thankfully, calculating it doesn’t require a master’s degree in applied mathematics. Even if you’re allergic to math, you owe it to yourself and the future of your business to have clear insight into your COGS.
What’s Included in COGS?
A simple way to think about COGS is all the costs involved with getting an item into your inventory and prepared for sale.
The following costs are often included in COGS:
- Product cost – how much it costs to order items from your manufacturer or distributor
- Freight in – how much it costs to get those purchased products delivered to you
- Duties and fees – any costs associated with design, kitting, or assembly of the products
In addition to these three, businesses may incur miscellaneous acquisition costs depending on the product.
What’s Excluded From COGS?
Now, there’s a whole lot more that goes into selling a product than what I’ve listed above.
But accounting professionals like to break these things out into other categories so business owners can observe and optimize things separately.
The following are things not included in COGS:
- Rent – for example, the monthly cost of your warehouse or storage facilities
- Online advertising – digital ads through Facebook, Instagram, or YouTube
- Payment processing fees – Stripe or PayPal per-transaction costs
- Product R&D – the design and development required to bring the product to its finished state
- Freight out – delivery to the customers
- Marketplace fees – charges from platforms like eBay, Etsy, or Amazon
- Employee salaries – this includes contractors like designers or market researchers
Owners must account for these expenses, of course. They simply record them in a separate line item — usually operating expenses (OPEX) — for more accurate analysis.
We’ll talk more about the relationship between COGS, expenses, and your overall profitability later in this post.
How Often is COGS Calculated?
COGS is not reported on an item-by-item basis but as a cumulative number over a predetermined time frame. For example, most businesses report quarterly for simplicity, but COGS can be calculated monthly or weekly if necessary.
At the end of every year, companies will aggregate their COGS for their annual financial statements.
Calculating COGS for eCommerce
Before we get into the nitty-gritty of calculating COGS, we need to establish a few prerequisites. Before beginning this exercise, you must have accurate and up-to-date:
- On-hand inventory numbers for all your SKUs
- Costs of ordering items from your manufacturer or distributor
- Revenue from products sold
If you’re not using digital warehouse management software like SkuVault as the hub of your inventory strategy, collecting this data will be a challenge.
Many digital solutions have a bevy of reports that you can generate in a few clicks. Reports like these in SkuVault aggregate data from across all platforms and channels and include your on-hand product.
If these numbers are buried in spreadsheets or are even a few dollars off, it can throw off your entire COGS calculation (and thus any subsequent net profit calculations).
SkuVault integrates with all popular accounting solutions like QuickBooks, so you can automate much of what we’re about to go over here. This gives you a high-level view of your margins at all times, as well as saves headaches during tax season.
With that caveat out of the way, let’s take a look at the formula.
The COGS formula is a relatively simple one:
Value of starting inventory + inventory purchases made during the reporting period – value of ending inventory = Cost of goods sold
This means if you start with $2,400 on-hand inventory when the quarter begins, purchase $5,000 of inventory during the quarter, and end up with a final inventory value of $4,000, your COGS for the quarter would be $3,400 (2,400 + 5,000 – 4,000).
But how do we arrive at these numbers? That all depends on how you decide you value your inventory.
COGS Inventory Value Calculation Methods
There are three main ways to calculate your inventory value:
- FIFO – First In, First Out
- LIFO – Last In, First Out
- WAC – Weighted Average Calculation
Let’s look at a hypothetical example and apply each of these methods in sequence to arrive at our COGS. Then, we’ll review ideal scenarios for employing each of them.
These numbers can get confusing, so let’s use a simple scenario with nice, whole numbers.
Consider the following order report:
|MONTH||UNIT AMOUNT||COST PER UNIT||TOTAL COST|
Let’s say we purchase 300 units of a particular SKU (reflected in the above chart) and sell 150. This leaves us with 60 units of unsold inventory.
Let go over how we’d calculate the value of our inventory using each of the above methods:
Calculating COGS with FIFO
FIFO assumes that you sell your oldest inventory items first. It’s helpful when you have lots of similar (or identical) items that wouldn’t benefit from individual tracking. Since you’re getting rid of the inventory you purchased first, you value your ending inventory based on what you’ve most recently purchased.
In FIFO, our COGS in the above scenario would be $200. Why? Because we calculate the January items first at $1.00 each ($100), then calculate the remaining 50 items from the February category at $2.00 ($100).
We’d calculate the value of the unsold inventory by just going down the line — 50 more units at $2.00, plus the last 100 at $3. This means our ending inventory value would be $400. Like I mentioned above, we’re valuing our ending inventory on what we’ve most recently purchased.
FIFO is pretty much the gold standard for companies today. It offers the most accurate number because it values the most recently purchased items. This means current costs will more closely match your actual inventory value.
Calculating COGS with LIFO
LIFO is the inverse of FIFO. We flip the equation in this one by calculating the cost of our sales based on our newest items and the value of inventory based on our oldest items.
This is because, as the name implies, we’re getting rid of our newest items first and saving our older items for inventory valuation.
In a LIFO valuation, we’d simply invert the order of our calculations. We’d follow the same pattern of FIFO, just moving in the opposite direction.
This means our COGS would be $400 and the value of our remaining inventory (150 units) would be calculated by our oldest orders. This gives us $200 (100 units at $1 in January and the remaining 50 units at $2 in February).
LIFO is helpful for tax deductions, as the higher your COGS, the lower your taxable income. When costs are rising, LIFO affords business owners steeper deductions because it factors in the higher-cost items in the COGS total.
Calculating COGS With WAC
A weighted average is a good back-of-the-napkin rough calculation for COGS. Its main advantage is that it smooths out price fluctuations.
However, it’s the least accurate of the three methods, and therefore should only be used internally. In fact, the IRS doesn’t accept WAC for valuing inventory on tax forms.
Taking a simple average of our purchase prices brings us to $2. From there, getting our COGS and inventory value is easy. We just multiply both figures by $2, leaving us with a COGS of $300 (150 sold * $2) and an ending inventory value of $300 (150 remaining * $2).
Using COGS to Calculate Gross and Net Profit
Phew! We made it to the other side of all those equations. For those of you who don’t have a background in accounting, that probably felt like drinking from a firehouse.
If you do not fully understand each calculation method, go back and read very slowly. Even better, try to plug in some of your own numbers so the concepts really sink in.
Once you have COGS, you can unlock a whole host of other insightful metrics such as gross and net profit.
Simply plug your data into these formulas:
Gross profit = Gross Revenue – COGS
Net profit = Gross Revenue – COGS – Expenses
From there, you can quickly discern whether or not you’re in the red or in the black, and brainstorm necessary tweaks to grow your profitability.
Simplifying and Automating Your Growth
It’s annoying to have to deal with this. The metrics mentioned in this post — especially COGS — are important and shouldn’t be neglected.
They empower business owners to work off of data-driven facts, not gut feelings or estimates. As such, you can make confident plans to scale your profitability and efficiency.
However, they don’t need to consume your life. Utilizing technology to gather reliable data and automate these calculations allows you to get back to things you care about in your business.
Tools like SkuVault can help you automate critical metrics and produce accurate, up-to-date data needed for advanced financial analysis. SkuVault also integrates with all modern accounting software. This enables you to maintain accurate books and prevents financial data from getting siloed in separate systems.
For more info on how SkuVault can help you scale your eCommerce business, reach out to our team for a live demo today.