What is the Cost of Goods Sold (COGS) and How to Calculate It?

Attention, Ecommerce Entrepreneurs! Uncover the crucial element of your business: COGS (Cost of Goods Sold). Learn to calculate it, boost profitability, and optimize pricing strategies. Master this vital aspect for...

What is the Cost of Goods Sold (COGS) and How to Calculate It?

Hey there, beautiful people!

I hope you're having a fantastic weekend so far! I'm currently sitting in a cozy coffee shop, enjoying my day off. However, when I tried to order my favorite coffee, I was disappointed to find out that they had run out of stock. This reminded me of the importance of inventory management for businesses. It's crucial to keep track of your stock to avoid stockouts and disappointing your customers.
Now let's relate this to the world of Ecommerce. One of the most critical aspects is inventory management. Efficiently managing your inventory is essential to prevent two scenarios: overstocking and understocking. Overstocking ties up your capital, while understocking leads to stockouts, leaving customers waiting and potentially losing their patience.

I've decided to write this blog post and start by discussing the concept of Cost of Goods Sold (COGS). You might wonder why I'm not jumping straight into inventory management. Well, that's because COGS is the foundation of everything. It affects inventory return ratio, forecasting, safety stock, reorder points, and much more. So bear with me as I pour my energy into creating valuable blogs, ebooks, and digital products.

Alright, this post might be a bit long, but trust me, it's packed with useful information. I'm going to address the following Q&A:
Q1. What exactly is the Cost of Goods Sold (COGS)?
Q2. How do we calculate COGS?
Q3. What are the common methodologies for calculating COGS?
Q4. Why is it crucial to consider COGS in your business?
Stay tuned for an enlightening read that will enhance your understanding of this fundamental aspect of Ecommerce.

Q1. What is the Cost of Goods Sold (COGS)?

The Cost of Goods Sold (COGS) refers to the direct costs involved in the production and delivery of goods. It encompasses expenses that are directly attributed to the goods sold and can vary based on the number of units sold. To determine the COGS, indirect costs are excluded from the calculation.

Now, you might be wondering about the distinction between direct costs and indirect costs. Let's explore some examples:
Direct Costs:

  • Manufacturing costs
  • Direct labor
  • Direct materials
  • Freight and shipping
  • Fulfillment costs (*)

 Indirect Costs:

  • Marketing costs
  • Distribution costs
  • Administrative costs
  • Rent
  • Management salaries
  • Fulfillment costs (*)

 Please note that the precise components of COGS can vary depending on the nature of your business. Regarding fulfillment costs (*), whether they are considered direct or indirect costs depends on how you allocate them and the nature of your business. Here's a general guideline:
Direct Cost: If your fulfillment costs are charged per order or per unit, such as a fixed fee per item or a pick-and-pack fee, they would be considered a direct cost. These costs can be directly allocated to individual orders and may vary based on the number of units sold.
Indirect Cost: If your fulfillment costs are not directly tied to individual orders or units but rather incurred as general operational expenses, they would be considered indirect costs. This category can include expenses like warehousing fees, inventory management, and ongoing charges for utilizing third-party logistics (3PL) services.
Ultimately, as an Ecommerce Entrepreneur, it's up to you to determine how to handle these cost allocations based on your specific circumstances and business requirements.

Q2. How to calculate COGS?

I'm pretty sure you've come across this information in the vast sea of the internet, but I'll echo it here once more:

To calculate your Cost of Goods Sold (COGS), you need to add together your starting inventory and your inventory purchases, and then deduct your ending inventory from that total. The formula looks like this:

COGS = Starting Inventory + Purchases - Ending Inventory

Typically, the beginning inventory is nil (0) for newly established businesses.
Here are the steps you might need to execute, particularly if you're newly established:

Step 1: Determine Purchases
Depending on the nature of your business, whether you manufacture the products yourself or outsource them under a private label, most Ecommerce Entrepreneurs opt for a private label.

Step 2: Calculate the Ending Inventory
The ending inventory represents the inventory remaining at the end of the accounting period. Usually, it carries over to the next accounting period and forms the beginning inventory. However, you might choose to dispose of it at a lower, zero, or negative margin by selling it, giving it to charity, or treating it as waste. To calculate the ending inventory, subtract the inventory that has been sold from the beginning inventory plus purchases.

Step 3: Apply the COGS formula
Let me provide an example: I run a business selling baby toys, specifically music boxes. I placed an order with a factory in Thailand for goods worth $30,000. At the end of Q1/2023, the value of my inventory at the 3PL's fulfillment center is $9,000. Therefore, my quarterly COGS would be calculated as follows:
COGS = Starting Inventory + Purchases - Ending Inventory
COGS = $0 + $30,000 - $9,000
COGS = $21,000

In the given example, I made only one bulk shipment for my purchases during the specified period.

Q3. Common methodologies to calculate?

The example I provided earlier was a simplified explanation, but from an accounting perspective, when your Ecommerce business scales up and you have a well-structured balance sheet, your accountant might employ the following methods to calculate COGS:

  1. FIFO (First-In, First-Out):

The FIFO method assumes that the first goods purchased or produced are the first to be sold. This means that the oldest inventory is considered to be sold first, regardless of any recent changes in the cost of inventory. The COGS is calculated using the cost of the oldest inventory.

For instance, let's revisit the example of my music box business in the first quarter. I purchased 1000 music boxes at a cost of $30 per unit. Later in the quarter, I purchased an additional 900 music boxes at a cost of $35 each. During this period, I sold 1100 music boxes.

Using the FIFO method, the COGS would be calculated as:
COGS = (1000 x $30) + (100 x $35)
COGS = $33,500

Since prices generally increase over time due to inflation, a FIFO business typically sells its least expensive products first. This results in lower COGS and higher net income in the long run.

LIFO (Last-In, First-Out):

The LIFO method assumes that the most recently purchased or produced goods are the first to be sold. This means that the most expensive inventory is considered to be sold first, leading to higher COGS and lower net income.

WAC (Weighted Average Cost):

The WAC method calculates COGS based on a weighted average of all the goods in stock, without considering the specific date of production or purchase. This method takes into account the quantities and costs of all inventory items and assigns a weighted average cost to determine COGS. As a result, it is less influenced by cost fluctuations over time.

Each method has its own implications for the valuation of inventory and the calculation of COGS. Your accountant will determine the most appropriate method to use based on your specific business needs and the regulations in your jurisdiction.

Q4. Why should we consider the factor of COGS?

As I mentioned earlier, COGS has a big impact on your business. It's a versatile and informative metric that plays several roles in ecommerce. Understanding COGS is important for the following reasons:
Financial Analysis: COGS is a key component in assessing your business's profitability.

By calculating COGS accurately, you can analyze your gross profit margin and determine how effectively you're using your resources to generate revenue.

Pricing Strategy: COGS provides valuable insights when setting prices for your products. Knowing the direct costs involved in producing and delivering goods helps you establish competitive and profitable pricing strategies, ensuring you cover expenses and achieve desired profit margins.

Inventory Management: COGS is closely linked to inventory management. It helps you track the value of your inventory and make informed decisions about stock levels, reordering, and supply chain management. Accurate COGS calculations enable you to optimize inventory turnover, avoid overstocking or stockouts, and minimize carrying costs.
Financial Reporting: COGS is a vital element in financial statements like the income statement and balance sheet. It gives a clear picture of the costs directly associated with the goods you've sold, allowing for accurate financial reporting and compliance with accounting standards.

While COGS is valuable, it does have limitations. It may not capture all inventory-related changes, such as loss, damages, or donations. Regular physical inventory counts and accurate record-keeping are crucial to ensure reliable COGS calculations and minimize errors.

It's also important to watch out for potential manipulation of COGS. Some individuals may try to manipulate manufacturing costs, overstate discounts or returns, or misrepresent inventory values. By implementing proper controls and auditing processes, you can protect against fraudulent practices and ensure accurate financial reporting.

In a nutshell, understanding COGS empowers ecommerce business owners with knowledge and insights to drive success. Your success matters to me, and I'm grateful for the opportunity to share this information. Stay tuned for more insightful blogs in the future!




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