Cost of goods sounds like one of those measurements that should be straightforward to calculate. You use a certain amount of fixed costs to produce a certain amount of goods, perform some simple addition, job done…right?
It’s easy to make mistakes when calculating the cost of goods formula. This can lead to founders scratching their heads and wondering why their cost of goods is too high. Or maybe you’re not even sure where to start. This article will help you understand the cost of goods formula and avoid obvious mistakes, saving you time, and maybe some money!
The rise and rise of eCommerce during the last few years (particularly during the Covid-19 pandemic) has invariably transformed consumer behaviour. This transformational shift away from bricks and mortar and towards online eCommerce businesses has led to a large number of new startups looking to gain early mover advantage in this growing market. Existing retailers and businesses have turned to eCommerce as a way to provide continuity for their businesses, while customers have been switching to alternatives while locked down with a larger disposable income. This shift towards online shopping and home delivery has changed the retail landscape forever, more and more businesses will move online in order to remain competitive.
What exactly is cost of goods sold, and what isn’t it?
Cost of goods sold (COGS) means exactly that. It’s the direct cost incurred by a company when producing goods. The cost of goods sold includes such things as the cost of raw materials and the wages of employees employed in producing goods.
COGS can sometimes be referred to as cost of sales, this language may better describe the COGS for your business, depending on the goods or service you provide.
COGS is used in the calculation of many other metrics, making it important to get right. An inaccurate COGS value can result in the financial health of your eCommerce business being wrongly presented.
What should we include in COGS?
Regardless of whether your eCommerce business sells physical assets or digital ones, every startup has both direct and indirect costs. Both of these have to be correctly accounted for in your cost of goods sold formula.
It’s important to understand that the COGS is the cost of acquiring/assembling/manufacturing the products that your eCommerce company sells. The costs included are only those directly tied to production.
Direct costs may include:
- Raw material
- Freight/Shipping (into your inventory only, not delivery to the customer)
- Payment processing fees
- Utility bills
Indirect costs may include:
- Office supplies
- Equipment rental
This is where it can get complicated, your COGS will include a mixture of both direct and indirect costs. Depending on the type of product/service your eCommerce business provides the market, you may include costs such as computers and telecoms as these could be directly tied to your product.
What isn’t included in COGS?
This is much easier to describe. We wouldn’t include costs that are not incurred by the production of goods. For example, costs incurred when selling the goods such as the salaries of your sales force, or any costs incurred by your corporate headquarters or fleet of company cars.
eCommerce retailers can have a variety of other costs related to conducting business. These range from customer shipping and payment processing fees (such as PayPal) through to marketplace costs and online advertising. Where these costs are not easy to classify as either related to COGS or not, seeking the help of accounting experts is advised.
Before we look at the formula, it’s essential that we consider the SOLD in the cost of goods sold.
Below is an oversimplification, but neatly demonstrates the point.
- Imagine a small luxury car manufacturer
- This year they produced 100 cars
- The complete cost to produce each car is £100,000
- The total Cost of Goods = £10,000,000
- This year they sell 90 cars
- The total Cost of Goods Sold = £9,000,000
There is an important difference between steps 4 and 6. For the time period used to calculate COGS, any products left in your inventory at the end of the period is NOT included.
Cost of goods sold formula
Let’s now look at the formula we need to complete our metric calculation.
Cost of Goods Sold = Inventory Start + Purchases (and Other Costs) – Inventory End
Seems easy, doesn’t it?
But each term of the cost of goods sold formula, as we learned earlier, is made up of other elements. Each term is important, and if neglected could lead to an equally important accounting error. This is where intelligent (and automated) accountancy software such as that provided by the accountancy cloud can really provide valuable support for your business.
Overall accounting approach
The COGS formula is made up of individual costs that are dynamic. Each year your COGS will change, and this is intuitive as you may have re-negotiated the price of your raw materials or your labour costs might have increased.
The fluctuating nature of your costs means that your inventory is made up of goods that cost differing amounts. Let’s imagine a warehouse where we store the luxury cars from earlier, the oldest cars have a COGS much higher than the newest cars stored there.
In other words, your accounting approach matters.
Here are four approaches you could adopt. It’s important that you pick an approach that suits your eCommerce business and supports your business goals.
FIFO – first in, first out. In other words, the earliest goods to enter your inventory are sold first. In general, prices rise over time, so companies that use the FIFO approach tend to sell the least expensive products to produce first. The FIFO method can be utilised by eCommerce companies with a range of different goods. This method most closely matches the inventory at the end of the period to your current costs.
LIFO – Last in, first out. This is the opposite of the FIFO approach. The latest goods to enter your inventory are sold first.
Average Cost Method – In this approach, the average costs of all the goods in your inventory is used to value the goods being sold. The date of their production is irrelevant. This strategy has the effect of smoothing out the impact of any spikes in costs or acquisitions.
The Specific Identification Method – This accounting method tracks individual items through your inventory. For example, Item X cost £10 to produce, Item Y £12 and Item Z £9. If a customer bought Item X, the COGS on that unit was £10. This approach is used most frequently on goods that are high value or bespoke.
What Does the COGS Tell You?
COGS is a very important metric. It can be found on a company’s financial statement and is used in determining gross profit. Gross profit, and gross profit margin, are useful metrics for any eCommerce business.
Businesses use gross profit margin to measure costs associated with production relative to revenue. If overtime gross profit margin is seen to be falling, prices might be increased, cost-cutting might be needed in the manufacturing process or cheaper suppliers might be found.
By measuring the gross profit margin for your business, you can identify areas of your operation that could be more efficient and ensure that as much profit as possible is available to the business in order to drive future growth projects. Comparing your metric against competitors operating in the same markets can also ensure that you’re not falling behind your rivals and remain competitive.
COGS is a cost of a company doing business. Being able to understand the COGS provides powerful insight to founders, managers, investors and analysts and helps them to assess the bottom line of a company. The relationship between COGS and net income is straightforward. If COGS increases, net income decreases. This can help business leaders evaluate the financial health of their company, by being able to manipulate net income by identifying costs that will have the biggest impact on their finances.
Covid-19 accelerated the move towards eCommerce in 2020 and 2021. Lockdowns across the world and the shutting down of non-essential businesses forced shoppers online. This opened up new markets, including new users of all ages accessing eCommerce for the very first time.
Traditional retailers have suffered during the pandemic, although supported (and in some cases propped up) by governments, many haven’t made it through. eCommerce retailers have had an unprecedented opportunity to take advantage of these conditions.
For a growing business to succeed it’s important that accounting methods are robust and accurate. To attract the investment that you need to take you to the next level, financial records and data need to show a true reflection of your operations.
Founders and entrepreneurs can use accounting metrics such as the cost of goods sold in order to make leadership decisions. Being to identify and separate individual costs can be really important to improving net income, as it allows you to re-negotiate that expensive contract or cut labour costs that have dramatically increased since last year. Tracking these metrics can only make your startup more effective, more competitive and more resourceful.
When you get metrics wrong, you get incorrect information and your decisions are based on faulty assumptions. If your COGS is underestimated, your gross profit and net income are inflated. If COGS is overestimated, the opposite is true. Both give the wrong impression of your financial health. If not corrected, these mistakes can be compounded over time.
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