Cost of goods sold (or COGS) is a key metric for businesses of all shapes and sizes. Calculating COGS gives businesses a very clear understanding of their performance—specifically inventory. The carrying value that gives ecommerce businesses a sense of profitability is really important for determining COGS accounting, too.
COGS doesn’t necessarily give you the full picture of your ecommerce 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 ecommerce brands.
It’s important for taxes, a gauge on profitability, and for planning for the future. At the same time, determining your COGS is limited on its own. 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.
COGS Accounting for Ecommerce
To get the full value out of COGS, ecommerce companies need to know how to calculate it. And with stiff price competition, comparison shopping and razor-thin margins, ecommerce brands must accurately model COGS (and other costs that affect profitability).
In one of our previous posts, we discussed the different methods to calculate COGS for ecommerce:
- 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. It’s the best model 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.
What Numbers Make Up COGS?
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.
How Other Costs Affect Profitability
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. Your profitability depends on many other costs.
Ecommerce 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. These costs certainly affect your profitability.
Any profitability analytics you engage in should take all of these disparate costs into account on a granular, order-by-order basis.