Will your business grow its net profit by increasing revenue or decreasing the cost of goods sold (COGS)? The answer isn’t so simple.
Increasing net profit (the money you keep) requires more sales (turnover) or lower costs. I know what you must be thinking. No kidding, Adii – tell us something we don't know.
Improving your net profit (the actual money that you keep) requires you to push the effort on driving revenue 📈and costs📉— jason wong (@EggrolI) April 21, 2021
Ways to save ⬇️
- Negotiate lower COGS with each larger PO you place, if you have a few months of history, leverage that
- Audit your expenses monthly
The fundamental foundations of running a business are easy to overlook once you are in the thick of it. And for many, getting more exposure (marketing), selling more products (sales), and upping turnover (revenue) become all too shiny obsessions.
After all, a business isn't a business without money; it's a hobby, right? You have to focus (at least some of the time) on driving up revenue to increase net profits.
But what if we put too much emphasis on the shiny ways to increase revenue and not enough on the fundamental best practices? Meaning, what if our pursuit of top-line growth is plastering over the cracks of our below-the-line inefficiencies?
If you google "How do I make more money for my business," most answers detail enticing marketing strategies and how-to steps centered around growth initiatives. Both lend themselves to plaster over the below-the-line cracks.
Very few focus on the fundamental principle of lowering your cost of goods sold alongside the idea of increasing revenue. It's not as shiny, but it's just as (if not more) effective.
What is the cost of goods sold (COGS)?
Cost of goods sold (COGS) is the direct cost of producing your company’s products. This inventory metric includes the cost of materials and labor costs used to manufacture products and get them to your warehouse or fulfillment center.
However, COGS does not include indirect operational costs (like warehousing, marketing, or shipping). These expenses are only deducted when figuring out your gross profit margin.
That said, your cost of goods sold is also critical in understanding gross profit margins. Because the lower your company’s COGS, the higher your margins and revenue. This means more cash flow and a better opportunity to grow sustainably as a brand.
What is included in the cost of goods sold?
For ecommerce stores, the cost of goods sold includes all of the direct costs associated with producing or acquiring your products for resale. This amount is sometimes referred to as the “wholesale” price of inventory, which covers the total costs of manufacturing and receiving products.
These direct costs include:
- Inventory purchased for resale
- Direct labor costs used for shipping products to the warehouse
- Raw materials or parts to assemble products or packaging
- Labor used to produce and assemble products or packaging
- Freight from your supplier to a 3PL warehouse
- Taxes (tariffs or duties) that add to the price of purchasing products
Frequently, brands will mistakenly include their operating expenses within their COGS. But because these costs are not directly associated with producing products, they should be excluded.
Indirect costs that do not contribute to your COGS include:
- Sales and marketing expenses, including Shopify, Amazon, or any other software fees
- Labor used to pick, pack, and ship products once they’ve been sold
- Overhead costs such as rent, utilities, insurance, and office supplies
- Legal or other general administrative costs of running a business
- The value of the inventory you haven’t sold yet
What is the difference between the cost of goods sold and inventory?
While sometimes used interchangeably, there are several differences between the cost of goods sold (COGS) and inventory.
Most notably: The cost of goods sold only includes the inventory you’ve sold to customers. It doesn’t apply to the stock you still have on hand.
This ending inventory is listed as an asset on the balance sheet, and it’s the biggest asset of any ecommerce company. Meanwhile, COGS is an expense on your profit and loss statement (P&L) and is deducted from your business revenue.
For example, let’s say a DTC beauty brand sold $50,000 in products over the year. At the end of the year, they still have $10,000 in inventory available.
In this scenario, the first value ($50k) includes the inventory cost and contributes to their overall COGS at year-end. The second value ($10k) is not included in COGS since these products are still an asset and yet to be sold.
Here is a table that summarizes the most notable differences between COGS and inventory:
|Cost of goods sold (COGS)||Inventory|
|Reported as an expense on the income statement||Reported as an asset on the balance sheet|
|The direct costs associated with producing products||The value of all finished goods on hand|
|Only applies to products that have been sold||Applies to all products that are still on hand|
|The cost of inventory is included in COGS||COGS are not included in inventory value|
|Not affected by accounting methods||Affected by accounting methods|
Understanding the difference between these 2 terms is critical for accurate bookkeeping. And brands that want to lower their COGS need to know what’s included and what’s not.
Why should ecommerce businesses care about COGS?
Knowing and tracking your COGS is the first step toward cutting costs, increasing revenue, and optimizing your operations. Here’s how COGS supports your business and brand growth:
Determines gross profit margin
Your gross profit margin tells you whether or not your brand is profitable. But you can only calculate this metric by first knowing your COGS.
Plus, when you understand how COGS plays a role in your company’s profit, you can proactively reduce them to improve margins and revenue.
To calculate your gross profit margin, use the following formula:
gross profit margin = (revenue - cost of goods sold) / revenue x 100
For DTC brands, you’ll also want to break down your COGS and gross profit margins by SKU, sales channel, and marketing initiative. This makes it easy to spot inefficiencies and make smarter planning decisions to lower COGS even more.
Offers insight into the costs of doing business
When brands only focus on top-line revenue, they forget how much it costs to run a business. Left unchecked, these expenses grow alongside revenue and throttle a brand’s cash flow.
But when you track your COGS, you know exactly how much it costs to make money. And you can make smarter purchasing, marketing, and sales decisions to reduce those costs as a result.
Helps calculate inventory velocity
In addition to gross profit margins, COGS also plays a role in measuring inventory velocity.
Inventory velocity measures the number of times your company sells and replaces your inventory in a given time period. A high inventory velocity means a risk of stockouts, and a low velocity means you have too much dead stock on hand (which increases your COGS).
To calculate inventory velocity (or inventory turnover), use the following formula:
inventory turnover rate = cost of goods sold / average inventory value
When brands have a healthy inventory velocity, they achieve inventory optimization. Meaning, they keep only enough inventory on hand to properly meet demand, reducing operational costs, increasing revenue, and improving the brand’s bottom line.
Keeps the IRS (and your bank account) happy
The IRS (or whatever entity taxes your income) wants to know how much your business makes to properly collect taxes on your revenue. Luckily, COGS are considered a business expense and don’t count toward your net income as long as you report them via an income or P&L statement.
These financial statements outline your revenue, COGS, and operating expenses. And they’re often used for tax purposes at the end of each fiscal year.
How to calculate the cost of goods sold
Many brands have accounting software or CPAs to calculate this metric for them. But it is possible to manually figure out the cost of goods sold (COGS).
To calculate COGS, use the cost of goods sold formula:
COGS = (beginning inventory + purchases) – ending inventory
To plug the right numbers into this formula, look for your:
- Beginning inventory – this is the value of your stock at the beginning of an accounting period
- Purchases – this includes any inventory purchased during the accounting period
- Ending inventory – this is the total value of all merchandise still on hand at the end of the accounting period
For example, say a store owner has $50,000 in beginning inventory at the start of the year. They made $10,000 in purchases throughout the year and have an ending inventory of $8,000.
According to the formula above, the COGS for this ecommerce brand is $52,000.
COGS = ($50,000 beginning inventory + $10,000 in purchases) – $8,000 ending inventory = $52,000 in COGS
That said, ecommerce brands should break down COGS by SKU for an in-depth look into how each product impacts profitability. So, you make better purchasing decisions for next year and can continue lowering your COGS.
How to lower your COGS
Lowering your cost of goods sold is easier said than done. So, where should you start?
Improve supplier relationships
Begin where you have the most real-time information available and often the upper hand: your supplier relationships.
Suppliers inevitably want (and need) long-term relationships with brands that order consistently. They also want to keep their cost to acquire customers (CAC) low. So, in most cases, you can bet that retaining existing customers like you is their top priority.
For instance, you can build trusting relationships with your suppliers by regularly submitting reliable, consistent orders. By doing so, you subsequently stack your bargaining chips for when your suppliers increase prices. This allows you to trade your order predictability for lower costs.
So, feel free to ask for a bigger discount on bulk orders or commit to minimum future purchase orders in return for a reduction in unit price.
You can even employ demand forecasting software like Cogsy to predict future demand for your best-selling products. Then, share those predictions with your supplier as leverage. (You can think of this as the Royal Flush in vendor contract negotiations.)
🤿 Dive deeper: A complete guide to vendor negotiations.
Protect your working capital
Working capital is the available capital for funding growth initiatives. And it depends on cash in the bank, debtors, creditors, and, often, the most prominent component, the size of your inventory.
In other words, working capital is the fuel that drives business growth.
For ecommerce brands, holding the wrong stock or even too much of the right stock could mean tying up cash that could, and should, be used to fund growth instead.
That's because not all products are created equal when it comes to inventory. When was the last time you looked at your slow-moving SKUs?
No one is saying it isn't wise to keep bestsellers on hand. But for those items that don't move as fast, elimination is a simple and effective way of releasing capital.
You can then put this extra cash towards funding larger, predictable supplier purchase orders (POs). And, as a result, upping your bargaining strength when it comes to lowering unit costs or shipping prices.
But that starts by being clever with your capital spending. Real-time prioritization of SKUs based on current trends can be done by looking at:
- Product sales velocity and volume
- The lifetime value of the customers purchasing these products
- The average order value of carts containing that SKU
You can also protect your working capital by controlling when specific SKUs are unavailable.
For example, try offering customers the option to order temporarily sold-out products on backorder. That way, you can see an uninterrupted revenue stream for that SKU, even when it isn't physically on the shelf. Plus, you can then bring this data back to suppliers as leverage to further lower COGS.
When it comes to product packaging, how luxe does it really need to be?
This is a question I dare you to ask yourself. And, in some cases, it might make sense to lower your standards (just a little). That's because taking even a few cents or grams off 1 package directly influences your delivery costs.
You'll also want to look at the delivery cost per product. This might make a case for bundling similar items to increase your average order value (AOV) and decrease delivery costs compared to shipping each item separately.
Evaluate shipping zones
What zones are you shipping to? Where is the bulk of your orders going? And how much is it costing you to get them there?
The key here is to look at optimization: You could relocate or even introduce fulfillment centers to the areas you often ship to.
For example, Forbes shares how US-based electronics retailer Best Buy used spotting a 2020 trend to transform physical stores into fulfillment centers.
Following Amazon’s giant footsteps, they own most of their fulfillment process. As a result, the company controls the delivery date and all its customer communications, keeping its shipping costs more competitive.
4 ways to value your inventory under GAAP
There are 4 generally accepted accounting principles (GAAP) for valuing your inventory and satisfying the IRS. Each one looks at inventory (and COGS) differently, so it’s important to choose 1 principle and stick with it.
The first-in-first-out (FIFO) method is based on the idea that the first inventory purchased is the first inventory sold. Because prices typically rise, this method helps decrease COGS by first selling the most expensive (AKA the longest-sitting) products.
FIFO is also the most popular option for perishable goods or products with a short shelf-life.
The last-in-first-out (LIFO) method is based on the idea that the newest inventory is sold first while the oldest inventory remains in stock. LIFO is generally an uncommon approach for DTC brands unless inventory prices are rising (and they need to get rid of the most expensive stock first).
Generally, the LIFO method tends to increase COGS and decrease net revenue. But this may help some businesses save money on their taxes by reporting a lower income.
Weighted average cost method
The weighted average cost method takes the average cost of all inventory on hand to value the costs of goods sold (regardless of the purchase date). This method is ideal for mass-produced products that don’t need to be broken down by SKU.
To calculate your weighted average cost, use the following formula:
weighted average cost = total inventory value / total units in inventory
For example, let’s say your brand has $5,000 worth of inventory on hand and 800 units available for purchase. According to the formula, your weighted average cost would be $6.25 per unit.
weighted average cost = $5,000 total inventory value / 800 total units in inventory = $6.25 per unit
You can also find your weighted average cost COGS by multiplying your weighted average cost by the number of units sold. For instance, if you sell 500 units, your COGS would be $3,125.
Specific identification method
The specific identification method tracks every item in your inventory from when it’s stocked to when it’s sold. This method is ideal for high-margin products with varying costs that need to be distinguished from 1 SKU to the next.
That said, brands will need a system for tracking individual items with an RFID tag, serial number, or receipt date. It cannot be done (at least with accuracy) manually.
Flipping the growth equation
Instead of plastering over the below-the-line cracks (caused by inefficiencies in pursuit of top-line growth), we should prioritize not letting them form in the first place. But to do that, you must ensure that the various below-the-line activities are always moving in the right direction.
Your COGS (including shipping and delivery costs) often presents the biggest opportunity.
That's because minor, incremental improvements in your operations lead to a reduction in your COGS. This not only protects and optimizes your working capital but also strengthens the core of your business. And as a result, your business is set up to grow.
Cogsy can play a crucial role in optimizing your COGS
- More accurate demand forecasting gives suppliers more predictability, which you can leverage to lower your per-unit costs.
- Better demand forecasting leads to better demand planning, so you only keep the inventory you need on hand to avoid unnecessary carrying costs or potential dead stock
- On-demand access to real-time inventory data, KPIs, and actionable insights that help your brand move these metrics in the right direction (AKA, optimize your operations)
Combined, these Cogsy features help brands maintain optimal inventory levels and reduce operational costs. This consequently lowers their COGS, improves profit margins, and frees up working capital (that was once spent on inventory). As a result, brands can reduce costs as they grow and scale their brands better.
But don’t just take our word for it – try Cogsy free for 14 days.
Cost of goods sold (COGS) FAQs
Get answers to the most common cost of goods sold (COGS) questions.
How to calculate ending inventory without the cost of goods sold?
Ending inventory is the total value of all merchandise still on hand at the end of the accounting period, and it can only be calculated if you know your COGS. To calculate your ending inventory, use the formula: beginning inventory + net purchases – COGS = ending inventory.
Is the cost of goods sold an expense?
The cost of goods sold (COGS) is not an asset or liability of the business. Rather, COGS is an expense for "doing business." And in this case, it means the direct costs of producing or acquiring products.
What is the difference between the cost of sales and cost of goods sold?
There is no fundamental difference between cost of sales and cost of goods sold (COGS). Both metrics outline the costs of producing goods. But typically, retailers and service companies use cost of sales on their income statements, while DTC brands use COGS.