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With the potential to influence everything from profit to liability, inventory calculations hold a lot of weight for ecommerce businesses. Yet understanding the nuances behind each formula isn’t easy. It’s one thing to know what Cost of Goods Sold (COGS) means and another to know how to calculate COGS in the most effective and accurate way possible. 

This article will give you a crash course on COGS, how it’s used, and how to calculate COGS as an ecommerce business. 

What Is Cost of Goods Sold (COGS)?

COGS represents the cost of materials and labor directly used to create products sold within a defined period of time, usually a month.

For instance, an online clothing store’s COGS would include the expenses involved in sourcing fabrics, manufacturing garments, and paying wages to workers directly involved in the production process. Similarly, a dropshipping business’ COGS would consist of the wholesale price of its products, along with any shipping and handling costs incurred in getting those products to customers.

COGS subtracted from total revenue derives gross profit margin – a crucial metric that indicates performance in production cost and operational management.

COGS vs. Operating Expenses

COGS shouldn’t be confused with operating expenses – another important metric used in accounting. Where COGS represents the combined costs of producing inventory sold, operating expenses encompass the broader spectrum of costs necessary to keep an ecommerce business operational. These expenses include rent for office or warehouse space, utility bills, taxes, marketing expenses, employee salaries not directly involved in production, and other administrative costs. 

Operating costs are generally fixed and must be paid regardless of whether any product is sold. COGS, meanwhile, is considered a variable cost because it rises or falls in direct relation to the number of units produced and sold. While COGS directly impacts gross profit margin, operating expenses affect net profit margin, which accounts for all expenses, including both COGS and operating expenses.

Expenses That Can Be Included In COGS

Generally speaking, only costs directly tied to the production of goods are included in COGS. However, many ecommerce businesses opt to factor less-directed expenses like shipping fees, packaging, and fulfillment costs into it as well. All other spending is considered an operational expense. COGS counts the cost of inventory that has been sold, while additional inventory that hasn't been sold is recorded as an asset line item on the balance sheet. Examples of expenses included in COGS have been listed below. 

Cost of Materials: The amount the ecommerce business pays suppliers for the materials for or complete products it sells to customers. For example, the wholesale price of jeans, shirts, shoes, and accessories.

Product Assembly or Customization Costs: If the ecommerce store sells products that require light assembly or customization before shipping to the customer, the labor costs go into COGS. An example would be an online store that embroiders logos on apparel.

Transaction and Payment Processing Fees: Costs incurred when customers make a purchase, such as credit card processing fees, PayPal fees, or fees charged by the ecommerce platform (like Shopify or Amazon Seller fees).

Warehousing and Storage Costs: If the ecommerce business stores its own inventory, expenses for leasing warehouse space, utilities, insurance, security, and warehouse staff salaries are included in COGS.

Fulfillment Costs: Ecommerce businesses that outsource order fulfillment to a third-party logistics company (3PL) should include the fees charged by the 3PL in their cost of goods sold. Otherwise, the in-house expenses of labor for order picking and packing can be factored in. 

Freight Costs: The cost of transporting products from a manufacturer or supplier to the ecommerce company's warehouse or fulfillment center, plus duties, taxes, tariffs, and any costs associated with customs documentation. 

Shipping and Handling Costs: Expenses related to packaging and shipping orders to customers, including boxes, mailers, labels, tape, and postage or shipping fees charged by carriers like USPS, UPS, or FedEx.

How to Calculate COGS

COGS calculations are case-specific. In order to obtain accurate final figures, you’ll need complete data on your ecommerce business’ spending, inventory value, and sales. It’s also worth noting that this information may be framed differently depending on whether U.S. Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) apply. 

Here’s a walkthrough of the main steps and considerations involved in calculating COGS:

1. Define Direct vs. Indirect Costs

Accurately defining direct and indirect costs is key to a proper COGS calculation. As mentioned earlier, this metric only assesses the expenses associated with producing and preparing goods for sale. Indirect operational costs such as employee wages and rent don’t contribute to COGS in a meaningful way.  

If your ecommerce business sells handmade candles, for instance, the wax, wicks, fragrance oils, and glass jars used to make those candles would all be included in COGS. The cost of the labels, custom shipping boxes, and any special packaging inserts would also count. But the fees paid to the graphic designer who created your logo would not, as they aren't directly involved in producing the candles.

That said, the definition of a direct cost can vary from business to business and even product to product. For example, subscription boxes and product sample kits often include special slips and inserts, which need to be considered when determining COGS for those specific packages. 

2. Determine Beginning Inventory, Ending Inventory, and Cost of Purchases

Inventory levels and purchases have a significant impact on COGS. Beginning inventory refers to the value of all products, parts, and materials in stock at the start of the accounting period. Ending inventory is the value of goods on hand at the end of the period.

Purchases include the cost of all items bought throughout the period to manufacture products, such as raw materials and packaging. Just like direct and indirect costs, beginning and ending inventory levels can look different depending on the valuation method used.

Periodic physical counts are considered the best way to get a definite number, and therefore value, of existing stock. However, businesses usually only conduct full physical counts periodically because of how much time they take to complete. Other strategies can be used as an interim gauge of inventory levels between physical counts. The one you choose may have a positive or negative influence on COGS and your bottom line.

Last In, First Out (LIFO): Assumes the newest inventory items are sold first. During periods of inflation, this results in a higher COGS.

First In, First Out (FIFO): Assumes the oldest inventory items are sold first. In an environment with rising prices, this results in a lower COGS compared to LIFO.

Weighted Average Cost (WAC): Takes the average price of all inventory purchased in a period. The weighted average cost is then used to value both COGS and ending inventory.

Specific Identification: Tracks the actual cost of each inventory item. This is generally only used for high value items like cars or custom jewelry.

Consider the products you sell and the resources you have available to determine which accounting method is best for your business. No matter which one you choose, be sure to apply it consistently across accounting periods. This will give you the most accurate picture of your inventory value and cost of goods sold over time.

3. Apply the Cost of Goods Sold Formula

Once you have compiled the information outlined above, calculate COGS using this formula:

COGS = Beginning Inventory + Purchases During the Period - Ending Inventory

How to Calculate COGS Example

Let's walk through a detailed example of calculating COGS for a hypothetical ecommerce business, ABC Clothing Co:

ABC Clothing Co. sells trendy apparel online. At the beginning of April, the company had an inventory balance of $50,000. Throughout the month, the business made several purchases – $20,000 worth of new summer dresses from a supplier, a $15,000 restock order of best-selling jeans, and $10,000 of new accessories – for a total spend of $45,000 on inventory.

Upon counting inventory at the end of the month, ABC Clothing Co. determines it has $40,000 of unsold products across its warehouses and fulfillment centers. Plugging these three numbers into the COGS formula would look like:

$50,000 + $45,000 - $40,000 = $55,000

Based on the math presented above, ABC Clothing Co.'s cost of goods sold for April was $55,000. This $55,000 would be reported on ABC Clothing Co.'s April income statement as COGS and then subtracted from revenue to calculate gross profit for the month.

Why You Should Calculate COGS

It may take a minute to fully understand and learn how to calculate COGS, but doing so is more than worthwhile. This one metric can add an unbelievable amount of context and confidence to the decisions you make as an ecommerce business owner. Let’s explore the benefits of COGS in more detail:

COGS Affects Profit Margins

Sustainable business growth hinges on healthy profit margins. Simply covering expenses is not enough; you need room for investment in business expansion and development. COGS serves as a vital tool for assessing profit margins at both a macro and micro level.

You can use it as a guiding compass in evaluating margins across entire product lines. A higher COGS generally means less profit per item sold and might be a reason to increase the price. Yet there are trade-offs to consider when doing so, such as potential impacts on customer satisfaction and demand.

COGS ultimately uncovers how margins stack up across the board so you can make well-informed choices on a case-by-case basis. It’s also a handy tool for gauging profit margin growth or shrinkage when market costs change, which, again, enables you to make decisions like renegotiating supplier contracts or strategically adjusting product offerings. 

COGS Uncovers Opportunities for Inventory Optimization

Businesses often need a dedicated logistics manager to simply ensure products are taken care of – let alone ordered, stored, and picked for shipment in a cost effective and efficient manner. COGS may help catch redundancies in these areas of inventory management.

For instance, let's say an ecommerce business selling custom printed t-shirts has seen its COGS steadily climb over the past year. That increase could be attributable to changes in warehouse leasing costs or supplier price hikes, but it could also indicate higher month-over-month holding costs due to excess inventory.

In such a case, the logistics manager might consider reassessing their demand forecasting strategy. COGS is a great surface-level gauge of ongoing expenses, which, when compared alongside other important supply chain KPIs and financial statements, can raise attention to overspending and create opportunities for future savings.

COGS Enables Better Record Keeping and Insight Across the Board

COGS analyses are only as helpful as the data used to make them is comprehensive. That’s why detailed record keeping is a core element of the calculation process – it ensures accurate numbers that fully reflect the amount of money your business pays for every product it sells. But there are additional benefits to tracking costs on such a granular level.

Knowing how to calculate COGS makes calculating the inventory turnover ratio and reorder point easier. You can use all of these formulas automatically with our free inventory management calculator to obtain in-depth insight into the health of your logistics operations:

Free Inventory Management Calculator

Perpetual inventory reporting systems can be equally leveraged to assess changes in spending on a variety of specific things over time, like supplies or shipping fees. Historic COGS data shows what has increased and decreased in price in the past while offering a roadmap for anticipating future shifts. Well-kept record books also come in handy should the IRS ever require you to substantiate deductions.

COGS Can Reduce Tax Liability

Even with a great profit margin, no business is immune to the financial drag of taxes. Luckily, COGS can help here as well by reducing the amount you’re liable to pay. The IRS allows for the deduction of production costs from total revenue alongside other business expenses like operating costs. The more there is to deduct, the lower your taxable income will be.

For example, let's say your business had $500,000 in revenue and $200,000 in COGS. If you had no other deductions, your taxable income would be $300,000 ($500,000 - $200,000).

However, if your COGS was $300,000 instead, your taxable income would only be $200,000. At a 21% corporate tax rate, the first scenario would result in a tax bill of $63,000, while the second scenario would mean a tax liability of only $42,000. The $100,000 difference in COGS would reduce taxes by $21,000.

It's important to track all production costs that can be included in COGS, as this can significantly reduce taxable income. Raw materials, labor costs, factory overhead, storage, and shipping costs can all potentially be factored in. Just remember that this deduction only applies to products that have actually been sold. You cannot include unsold inventory.

You don’t need to be an accounting expert to know how to calculate COGS from inventory levels. Gainfully acting on what you discover is another story. Cost-effective ecommerce inventory management requires ongoing attention from a dedicated logistics manager or VP of Operations. If that isn’t something you’re ready to commit to in-house, consider working with a 3PL provider. 

ºÚ°µ±¬ÁÏÍø’s outsourced solutions make it possible to benefit from the insights and guidance of industry experts without extra time, staff, or effort. Our real-time reporting technology can keep a close watch over important supply chain KPIs like COGS to ensure you’re always abreast of changes in the big picture. We also assign dedicated Account Managers to act as an on-site source of information and support. Discover what best-in-class 3PL services can do for you by contacting ºÚ°µ±¬ÁÏÍø today.