01 September How to Calculate Cost of Goods Sold (COGS)
Business metrics are critical to the management of any ecommerce business. You need to understand where your business is performing, and where you can make improvements to increase profits and efficiency.
Metrics like ROI or ROAS assist you in understanding how your business is performing overall, and how your investments are driving business growth. COGS (Cost of Goods Sold) helps you to look deeper into your inventory management and sales process.
Your COGS tells you exactly how much your inventory has cost you for a specified period of time.
This can help you to further understand where your profit margins can be improved, and how your sales are performing compared to your outgoings. You can also identify and estimate just how much investment is needed to continue operating your business for the next year.
So, how do you calculate your Cost of Goods Sold (COGS)? And how is this useful for an ecommerce business?
Put simply, COGS equals the amount of money you spend on purchasing or manufacturing your product. However, it doesn’t include marketing and sales costs.
What is Cost of Goods Sold?
Cost of Goods Sold is essentially exactly what it sounds like, how much you spent on the inventory or goods that you sold in the year. This might be the cost of producing inventory, if you manufacture your own products, or the cost of sourcing inventory if you’re a re-seller.
Your COGS helps you to calculate your company’s bottom line, and the potential to grow your profit margin. Ideally, you want to keep your Cost of Goods Sold as low as reasonably possible and you want to use this metric to optimize your profit margins.
As well as an important business metric, Cost of Goods Sold is a critical part of your business’s tax returns. You need to clearly report your business expenses, as COGS is directly related to the cost of doing business.
The metric is used to calculate your gross profit for the year. COGS is subtracted from your reported revenues, to understand just how profitable your business was for the tax year.
How to Calculate COGS
The basic calculation for the Cost of Goods Sold is relatively simple. The simple formula for calculating COGS is:
Cost of Goods Sold = Beginning Inventory + Purchases – Ending Inventory
If you are calculating COGS and you’ve been in business for more than a year, then start with your inventory cost at the start of the year that you’re calculating. Add your purchases/spending on inventory throughout that year. Then subtract the value of the inventory you have at the end of the year from this number. This will leave you with the amount you spent on the goods that were sold.
However, while the calculation itself might be relatively simple, it’s important to identify what is included within the inventory and purchase costs. For instance, if an expense occurs regardless of the sale or manufacture of goods, it cannot be included within COGS. Incorrect calculation and reporting of COGS can cause issues with taxes and mean that you’re not properly measuring your business’s performance.
Steps to Calculating COGS
Before you begin the calculation of COGS, you need to identify what is included within inventory and purchase costs. It’s critical that you only include costs that are related to the acquisition, handling, and manufacturing of your product offering.
Direct Costs and Indirect Costs
There are two types of costs included within COGS. These are direct and indirect. It’s important to understand these two costs, and how they impact the profit margin and cost of each sale.
Direct costs are those directly related to the production or acquisition of your products. This would include the cost of materials, and the cost of labor if you have a workforce. Direct costs can often vary, as material prices continue to rise along with the cost of staff. As a result, you will need to monitor direct costs throughout the year.
Indirect costs aren’t specifically related to the cost of the product, but the business costs required to operate and sell the products. These might include warehousing costs, logistics, administrative expenses, advertising, utilities and more.
You cannot attribute indirect costs completely to the production of goods. Therefore, these costs are only considered part of the Cost of Goods Sold if they add value to the product, in order to make it sellable. If this is the case, then you might need help from an accountant to accurately calculate how much indirect costs can be attributed to each item.
This is where your calculations start, once you understand what contributes to the costs. Your beginning inventory is the total value of your inventory at the start of the time period that you’re calculating – typically a tax year.
This value includes the purchase price of fully produced products, raw materials, anything in production, and anything in logistics that is under your ownership.
Your beginning inventory will be the same value as your ending inventory at the end of the previous tax year. Ideally, you should be keeping track of this value throughout the year, to avoid having to count manually at the end of each year.
Throughout the year, as your business grows, you will need to acquire more inventory. As long as you’re selling, you will need to stock up.
You should be keeping track of invoices as part of your management practices. These are critical to your end-of-year COGS calculation. You need to know how much you spent on inventory throughout the year, outside of your initial inventory value.
The combination of beginning inventory and extra purchases is your starting point for COGS.
Your ending inventory is the value of your inventory at the end of the reporting period. Again, this includes any full inventory, as well as the cost of any materials and anything held in logistics that is under your ownership.
However, at the end of the year, you can write off any damaged, destroyed or returned products. You can also edit the cost of older products, as long as it has decreased in value. You would need to prove that this is no longer in your inventory, or that the value has decreased.
Once you have calculated a clear value for each of these elements, you can carry out the COGS calculation.
The Importance of COGS for Ecommerce
COGS isn’t just a metric used on your tax return or for income tax purposes. It is valuable to further your understanding of your sales, inventory, and your profit margin.
Your Cost of Goods Sold demonstrates how much your inventory is costing you, relative to the revenue made from sales. If your COGS is high compared to your sales revenue, then your profit margin is smaller.
Any ecommerce owner should aim to have a high profit margin on all products. To do this, you need to reduce your COGS.
By calculating your COGS, you can understand where reductions can be made to keep costs down. You might identify that labor costs are stacking up, or you’re paying too much for utilities or logistics. It’s important to make reductions wherever possible during the production or acquisition process.
Ecommerce owners are likely to pay more for logistics and warehousing than traditional stores. Your products are all stored in warehouses and need to make the journey to the customer, rather than your customer coming to your store. Therefore, calculating COGS should help you to manage your production process and inventory, to improve your profit margin.
Your profit margin is the key to purchasing more inventory, making more sales, and continuous growth. It’s critical to make the most from each sale to secure the future expansion of your business.
Other Metrics You Need to Keep in Mind
COGS is just one of the metrics you need to keep your eye on as an ecommerce business or online seller. At Yardline, we understand the challenges that ecommerce business owners face. The combination of our capital offering, and ecommerce expertise, can set you on the path to continued growth. Get in touch with us today for up to $20 million in ecommerce funding.