Cost of Goods Sold, or COGS, can be one of the most difficult concepts for online sellers to wrap their heads around. Even if a seller understands the basic concept, it can be difficult to plug COGS into accounting software or report COGS in a way that gives you a clear look into your business’s financials.
Think of calculating COGS as an instant peek into your business’s health. Once you determine how much you are spending on each SKU, you can see if your business is truly profitable, or if you need to change course.
And hey, COGS is also a tax deduction!
Cost of Goods Sold, Defined
COGS is the direct costs associated with your sales. In e-commerce, this includes factors like:
- The amount you paid the factory or supplier for your goods
- Costs associated with fabricating your goods yourself
- Tariffs and duties
- Freight costs associated with obtaining your products
- Other miscellaneous fulfillment expenses associated with getting your goods into your customers’ hands
When you calculate your sales for a given month and then subtract your COGS for a month you are left with your gross profit. And who doesn’t want a clear picture of your gross profit? This is important when it comes to making further business decisions, such as determining if you are pricing your SKUs high enough to turn a profit.
Quick Tip: It’s important to understand that COGS is all about costs you incurred relevant to obtaining each piece of inventory and is not associated with overhead expenses for your business (such as office space rental, office supplies, or even shipping products to customers.)
How to Calculate COGS
There are two ways to determine your COGS, and each have their pros and cons.
Cash Basis Accounting
The pro of cash basis accounting is that it is the simplest type of accounting. For example, say you pay a vendor $10,000 for 1,000 units of an item. In your bookkeeping, you would expense this $10,000 right away.
However, the con of cash basis accounting is that you end up with terrible visibility into your actual profits. In months where you make large inventory purchases, cash basis accounting may make it look as if you lost money. While in months where you don’t make any inventory purchases you may feel that your business is insanely profitable. All the while, you may be somewhere in between, but you simply won’t know! Which brings me to…
Accrual Basis Accounting
In accrual basis account, rather than counting inventory purchases as an expense the month you purchase them, you expense the items you’ve purchased as you sell them.
This more hands-on method requires you to “park” your goods in an Inventory account in your bookkeeping software until you actually sell the goods.
The pro of using accrual basis accounting is that you have up-to-date visibility into the actual financial health of your business.
The con of this method is, of course, that it’s more difficult to do than simply tracking each expense in the month that you write the check. However, most accounting professionals prefer sellers use this form of accounting because it allows for greater visibility into your business’s financials.
Quick tip: The most important thing to note about accrual accounting is that, when it comes to keeping your books, spending cash doesn’t necessarily equal incurring an expense when it comes to your business bookkeeping. For example, say you purchased a truckload of products in October, but you didn’t actually begin selling those products until November. You would only count the money you paid for that truckload of inventory as an expense in November when you begin selling each SKU.
How to Account for COGS when Bookkeeping
Many e-commerce sellers complain that accounting for COGS is one of the most confusing aspects of keeping their business’s books. This how-to should help!
Step 1: Create a spreadsheet listing each SKU in Column A and a Per Unit Value for that SKU in Column B. Make sure Per Unit Cost includes the following:
- Factory cost (invoice total divided by number of units)
- Any tariffs and duties paid
- Freight costs to obtain inventory
- Other miscellaneous fulfillment costs (normally not FBA fees)
Step 2: Calculate how many of each SKU were sold in the month you are working with. (Example: SKU 479A – 10 units sold. SKU 480 – 15 units sold.)
Step 3: Multiply your Per Unit Cost by the number of units sold for each SKU. This will give you your total COGS amount per SKU.
Step 4: Then total each COGS amount per SKU. This will give you your total COGS amount for the month.
Step 5: Once you have your total COGS amount for the month, enter that value into your accounting system by pulling your total amount of COGS for the month from where you had it “parked” in your Inventory Asset and placing it into COGS.
Then pat yourself on the back. You’ve successfully calculated COGS!
Here’s an example of a financial report. Line 5000 is Cost of Goods Sold. As you can see, without that line and the other items under “Cost of Goods Sold” up top, the total “Gross Profit” on the bottom line would have been inaccurate.
But now that you’ve calculated COGS, you can see a true picture of the gross profit of your business. You are now armed with the financial knowledge you need to make healthy business decisions going forward.
For more about accounting for your inventory, check out our post Cash vs. Accrual: Inventory and Tariffs.
Do you need help calculating COGS? Contact us for a free e-commerce accounting consultation!