While it's important for all businesses to know their numbers, eCommerce retailers face the added challenge of easy comparison shopping and stiff price competition. Because this can mean operating on razor-thin margins, it's important to be able to track every cent in costs so that you can maintain profitability.
There are four general methods for calculating costs of goods sold.
The weighted-average method uses the average cost of all of your units and inventory. Unlike the other methods, it considers your inventory as a pool and doesn't track specific units or make assumptions about which unit sold first. The costs are weighted by the number of units.
Consider the following inventory purchases.
Your total inventory would be $1,865 (100 x $7 + 50 x $8 + 150 x $7.50). Your weighted-average cost per unit would be the total inventory ($1,865) divided by the total number of units (300). Rounded to the nearest cent, that's $6.22 per unit.
To find the weighted-average COGS, multiply the units sold by the average cost. If you sold 100 units, your weighted-average COGS is $622.
Best for: Keeping things simple when you have mass-produced, interchangeable items. Examples include off-the-rack clothing, nails, and water bottles. Order Metrics uses this method.
The specific identification method tracks each individual item of inventory. If unit A cost you $7, unit B cost $8, and unit C cost $7.50, and you sell unit B, your cost of goods sold on that order is $8.
Best for: High-value, unique, or customized items that you need to identify individually. Examples include cars, antiques, and build-to-order computers.
With mass-produced and/or non-unique items, inventory is considered as a pool rather than as individual items. Continuing the above example, you'd have a total inventory of $22.50 ($7 + $8 + $7.50).
With FIFO, the first unit you bought is considered the first unit you sold even though an employee filling the order may have actually grabbed a different unit. Assume that you bought units A, B, and C in order and then had two orders for one unit each.
Under FIFO, your COGS for the first order is $7 because you bought unit A first. Your COGS for the second order is $8 because unit B is the next unit you bought. Your total COGS for that period would be $15 – the sum of the COGS for each order.
You can also calculate COGS in aggregate. If you bought 100 unit A, then 100 unit B, then 100 unit C, and sold 150 units, you can find the FIFO COGS by adding up the cost of the first 150 units you bought. That would result in $1100 (100 unit A x $7/unit + 50 unit B x $8/unit).
Best for: Pooled items similar to the weighted-average method. FIFO most closely matches your ending inventory on your balance sheet to your current costs.
LIFO is the reverse of FIFO. Instead of assuming that you sold your oldest inventory first, you assume that you sold your newest inventory first.
Assuming you still bought one each of units A, B, and C, your initial inventory would remain $22.50.
In the two orders for one unit each example, your LIFO COGS for the first order would be $7.50 because you bought unit C last. Your COGS for the second order would be $8 because unit B was the last unit you bought before unit C. Your total COGS for the period would be $15.50.
Now let's change the larger volume example so that you still bought 100 of each unit but sold 250. To calculate LIFO COGS, you start with the last purchase and work backwards. To cover the 250 units in sales, you'd need 100 of unit C, then 100 of unit B, then 50 of unit A. Your LIFO COGS would be 100 unit C x $7.50 + 100 unit B x $8 + 50 unit A x $7 for a total of $1,900.
Best for: Pooled items similar to the weighted-average method. LIFO most closely matches your COGS to your current costs even if you don't sell all of your inventory. When your costs are rising, LIFO results in a higher reported COGS on your income statement and therefore lower taxable income.
To determine what to include in COGS, it's important to remember that COGS stands for costs of goods sold. COGS is the value of the goods, or inventory, that you ship.
COGS and inventory value should include the purchase price you paid plus any related ordering costs such as handling fees or freight costs to your warehouse. In short, your cost of inventory is whatever it takes to get the inventory in your hands. When you sell inventory, the cost of that inventory is added to COGS.
eCommerce retailers also have numerous other costs such as shipping to customers, order fulfillment, payment processing fees (e.g. Shopify Payments, PayPal or Stripe), marketplace transaction fees (e.g. eBay or Amazon), and online advertising (e.g., Facebook or Google). There are also more traditional costs such as employee salaries, electricity bills, and rent for a warehouse.
It's important to understand all of these costs, and they can generally be used to reduce your taxable income. However, they are not traditionally included within COGS because COGS measures the acquisition cost of the items that you sell.
Order Metrics tracks both COGS and other costs within a single tool. You can view a beautiful dashboard to track the total costs and profitability of individual products, advertising campaigns, shipping methods, orders, order combinations, and more. To learn more, watch our video or start your 21-day free trial.