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Cost of Goods Sold: What You Need to Know About Inventory
Is your business calculating the cost of goods sold accurately? Here is what you need to know about COGS.
Whilst an ecommerce business is complicated, getting the cost of goods sold under control is key having your financials in order. Accurate and efficient inventory management is arguably the most important element of any successful ecommerce platform as tieing down too much of your capital in inventory or prioritising low margin products can be draining on your cashflow.
Cost of goods sold, or COGS, is also the largest expense of any inventory based business and should be taken very seriously. Here is what you need to know about cost of goods sold management for your ecommerce business.
The Importance of COGS
If your business sells products, then it’s highly likely that your business manages inventory. If this describes your business, then it’s important you are aware of how to calculate the cost of goods sold, and how it impacts your bottom line.
Calculating the cost of goods sold includes every cost involved in selling your products. The process of calculating the cost of goods sold for the products you distribute, manufacture, or sell can be a difficult process, depending on how many products you sell and the complexity of the supply chain required to sell them.
The Relationship Between COGS and Inventory
Calculating the cost of goods sold depends on the overall value of the inventory your business manages. If your business sells a physical product, inventory is defined as the items that you sell. In some cases, inventory can be items that have been purchased from a wholesaler. In others, inventory can be products that your business has manufactured.
Other businesses may maintain an inventory of parts or materials that are used to assemble the products they sell. Regardless of the what comprises your inventory, it’s a critical business asset with a quantifiable value.
Calculating the cost of goods sold begins with inventory at the beginning of the financial year and ends with inventory at the end of the financial year. Most inventory based businesses take inventory at these junctures in order to calculate the value of their inventory.
In most cases, a business that launches and collects purchase inventory will place it in a warehouse facility, or with a third party logistics provider. This represents a significant initial investment that may not translate into sales for some time.
Recording the cost of inventory at the time of purchase, rather than waiting until inventory is sold, is a common mistake made by inventory based businesses. Taking inventory in this manner can cause irregularities in an income statement and presents a business as a less reliable investment.
What You Need to Know About Calculating Cost of Goods Sold
- There are a number of critical facts that ecommerce or inventory based businesses must understand about cost of goods sold:
- Cost of goods sold is the largest expense of an inventory business
- Incorrectly calculated COGS will result in errors when calculating taxable income
- Incorrectly calculated COGS will present inaccurate profit margin numbers
- Inaccurate profit margin numbers will cause friction in your business and make inventory management difficult
- COGS and profit margins directly affect decision making on pricing, marketing budget, and order quantity
Examples of COGS
Following is an example of how recording inaccurate cost of goods sold can significantly impact the key figures that impact the operation of your business
Example 1: Incorrect COGS
|Month 1||Month 2||Month 3|
In the above example, the company has recorded inventory costs within the same month the inventory was purchased, rather than waiting until inventory was sold. This practice has resulted in the recording of a -$15,775 loss in the first month.
Over the next few months, however, the business sold inventory but didn’t record any expense against sales — this makes income appear larger than it is in reality. Additionally, this practice impairs decision making. If the business in this example is trying to determine whether it has the capital to hire new staff or increased marketing expenditure, the obfuscated income calculation makes profit measurement nearly impossible.
Example 2: Correct Cost of Goods Sold
|Month 1||Month 2||Month 3|
In this example, the company has recorded COGS accurately. A prospective company assessing this business as a potential investment opportunity would find this example far more attractive, as the income statement is far more stable.
In example 2, cost of goods sold is expensed over time, in an incremental manner. This ensures that COGS is calculated in alignment with the volume of product sold.
When calculating COGS in the context of inventory purchases and income statements, it’s important to consider the time period in which you include cost of goods sold. When accounting for inventory purchases, it’s important to only include the expense on your business income statement as the product the expense relates to is sold.
Recording your inventory expenses incorrectly not only obstructs potential investors from capturing an accurate assessment of the value of your business, but also makes it more difficult to make informed business decisions.
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Stuart Reynolds is the founder of Fullstack Advisory, an award-winning accounting firm for businesses leading the future. He is a 3rd generation accountant who specialises in tech companies, agencies and entrepreneurs.