Cost of goods sold (or COGS) has long been a key metric for businesses of all shapes and sizes. Calculating COGS gives businesses a sense of how well their inventory has done and will continue to do into the next year. It’s this carrying value that gives e-commerce businesses a sense of profitability.
COGS doesn’t necessarily give you the full picture of your e-commerce business’ profitability, but it does give a baseline to work with. It’s the cost of your inventory, which often ends up being a major cost for e-commerce brands.
COGS is important for taxes, a gauge on profitability and for planning for the future. At the same time it’s limited on its own, since it doesn’t necessarily account for all the costs that affect true profitability.
In this brief guide we cover both what is included in COGS and how other costs may affect the profitability of your e-commerce business.
To get the full value out of COGS, e-commerce companies need to know how to calculate it. And with stiff price competition, comparison shopping and razor-thin margins, e-commerce brands should be able to accurately model COGS (and other costs that affect profitability).
In one of our previous posts, we discussed the different methods to calculate COGS for e-commerce:
Weighted-Average Method: The average cost of all your units and inventory. This model treats your inventory as a whole, and doesn’t take specific units into account. Multiply the units sold by the average cost.
Specific Identification Method: This takes a specific cost into account for each unit. The model is best for high-value, unique or customized items you need to identify individually.
First-In, First-Out (FIFO): This model takes a running aggregate view of COGS, assuming that you will both purchase and sell the same unit first. FIFO will most closely match costs with your ending inventory on your balance sheet.
Last-In, First-Out (LIFO): This model assumes you sell your newest inventory first. Since LIFO reflects current costs regardless of current inventory, LIFO results in a higher reported COGS.
For more detail on these four models for COGS, see our past posts on calculating costs of goods sold.
Accounting firm Ledger Gurus give a fantastic explanation for the form and function of COGS:
“At the end of each month you should have revenue and COGS on your profit and loss statement reflective of the margin you enjoyed on those products at the time of their sale. Then, your balance sheet should also show an inventory balance reflective of all the product you have remaining. Together, these two numbers give you an accurate picture of where you stand with inventory and COGS and, more importantly, where you stand on gross margin.”
But what costs actually go into calculating COGS? Here are some of the main costs associated with cost of goods:
Cost of Materials: The most direct cost in COGS, this includes the parts used to make your products (or source them from the manufacturer), raw materials, and items purchased for resale.
Cost of Labor: This accounts for what you pay employees who work directly on creating your products (even if you purchase them from a manufacturer). It includes everything from warehouse costs to what the manufacturer pays employees. This doesn’t account for employees working on other tasks, like marketing or sales.
Overhead Costs: These include utilities and transportation costs directly related to your products up to the point when they enter your inventory (i.e. this doesn’t include shipping costs to your customers). It also includes the software needed to acquire your products.
COGS is included as a separate line on your balance sheet, but it’s not the only line. COGS measures the direct acquisition cost of the items that you sell; but your profitability is dependent on many other costs.
E-commerce brands have multiple other costs not directly related to inventory: 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).
Other traditional overhead costs include employee salaries in marketing or sales, utility bills, warehousing costs and more. While these are not typically included in COGS, they certainly affect your e-commerce business’ profitability.
Any profitability analytics you engage in should take all of these disparate costs into account on a granular, order-by-order basis.