If you’ve looked through your business income statement, you have definitely come across the term “cost of goods sold.” In case, you aren’t aware of COGS or cost of goods sold, you should be, because it can make your ecommerce business run more smoothly and profitably.

Why’s that? To find gross profit, you must consider both revenue and cost of goods. Moreover, you can always find COGS on the second line of a business's income statement. So, you can’t go to the bottom without calculating this specific expense.

Now that you understand the importance of this ecommerce metric, let’s go over what cost of goods sold is and how you can calculate it, along with some tips and tricks.

What is Cost of Goods Sold (COGS)?

Simply put, cost of goods sold (COGS) is the price a business pays to produce the products or services they sell. This is the amount that the company should aim to recover from the sales so that they can break even and turn a profit. 

If the company has physical assets, these are typically valued at their current inventory value plus any associated materials and direct labor costs paid during the year. Any direct expenses a company incurs during the production, acquisition, or resale of items are included as well. 

Cost of Goods Sold vs Operating Expenses: How Do They Differ?

Although the cost of goods sold and operating expenses are used when calculating profit, they have different functions. Operating expenses refer to indirect costs required for daily operations, whereas COGS reflects the direct costs related to production as we mentioned above. 

Some examples of operating costs include rent, employee salaries, insurance, marketing initiatives, and more. As you can see, these aren't directly related to the sale of products.

COGS illustrates a product's profitability and indicates whether adjustments, such as raising prices or trying to cut supplier costs, are required. Comparatively, operating expenses focus more on how effective the company operations are, in addition to "long-term" investments. 

Let’s go through an example to understand the difference between the two:

Suppose you’re starting the fiscal year with $5,000 worth of old inventory and you have an additional supply worth $7000, and finally at the end of the year you’re left with $2,000 in inventory. So your cost of goods sold would be $5,000 + $7,000 - $2,000 = $10,000.

But what about operating expenses?

Consider your rent to be $50,000 in a year, along with overhead costs being $4,000, and inventory costs around $3,000. We can then calculate operating expenses to be $50,000 + $4,000+ $3,000 totalling $57,000.

Now you know how to calculate these two metrics, but let’s find out what is the formula for calculating cost of goods sold.

Calculating Cost of Goods Sold

While calculating cost of goods sold might look simple, it’s not just about adding direct expenses one after the other. That’s why we’ve shared this general formula you can use for your income statement or even your balance sheet.

Cost of Goods Sold Formula

Without further ado, here’s the formula for calculating cost of goods sold:

Cost of Goods Sold = Starting Inventory + Cost of Buying or Manufacturing New Inventory - Ending Inventory

In this way, COGS is primarily used to calculate the "true cost" of the goods sold during the period. Let’s break down each component as well for your better understanding:

  • Starting inventory: refers to the inventory rolled over from the previous year or period. This is usually because the inventory wasn’t sold before.
  • Cost of buying or manufacturing new inventory: total cost spent behind inventory throughout that specific year.
  • Ending inventory: inventory that wasn’t sold at the end of the year, so this will serve as the starting inventory for next year.

However, the cost of goods formula may vary from business to business as some may have other costs they’d need to consider. It depends on which business accounting method you use to assign value to your inventory, which ultimately affects your cost of goods sold. But we’ll discuss this more later in this article.

Cost of Goods Sold Examples: Using it in the Real-World 

You already know what is the formula for calculating cost of goods sold, but let’s try out some examples:

Example 1

Let’s imagine that in Q1 2024, company X had $7,500 left in inventory from Q4 2023, and to keep up with the demand, they purchased $10,000 worth of inventory. At the end of the quarter, they’re left with $4,000 in inventory. So we can calculate the cost of goods sold accordingly:

Cost of goods sold = $7,500 + $10,000 - $4000 = $13,500

Example 2

Another example could be company Z began the month with $6,700 worth of products, which she paid for upfront. Their inventory costs for the month totalled $5,000, which they used to order supplies for new items and some products to resell. Finally, their ending inventory at the end of the month was $8,000.

So, we could calculate the cost of goods sold for the month accordingly:

Cost of goods sold = $6,700+ $5,000 - $8000 = $3,700

Example 3

In 2023, ABC had $25,000 left over from their inventory from 2022, and they purchased $55,000 worth of new supplies or products. At the end of 2023, they had $35,000 left in terms of inventory. When you calculate the cost of goods sold, you’d get:

Cost of goods sold = $25,000 + $55,000 - $35,000 = $45,000

Reporting COGS on an Income Statement

By calculating the cost of goods sold, you can learn how much it costs to acquire the goods you wish to sell. So, this is necessary when doing calculations within your income statement as you need COGS to get gross profit. We can define it as the profit recorded by calculating net sales minus cost of goods sold.

Usually, COGS is shown immediately after sales revenue on the income statement, so it’s the second line item. But how do you input the cost of goods sold? 

FIFO Method

The acronym “FIFO” refers to first in, first out, which means that a business will start by selling its oldest inventory before its newest. It’s also assumed that the same business will be selling its more affordable products before its more expensive counterparts.

Consider the following scenario: you have bought some inventory units A, B, and C, and you’ve gotten five orders for each unit. But unit A comes first and you paid $10 for it, so your cost of goods sold under FIFO is $10x5 = $50. Given that unit A is depleted after the first 5 units, the cost of goods sold (COGS) on your subsequent order would change according to the price you paid for the subsequent unit.

LIFO Method

LIFO stands for last in, first out so you can probably guess that it’s the opposite of FIFO. So, the products you’re selling initially should be the ones you bought or made last. As prices rise, businesses might have to sell their products for more money, which would raise COGS. However, this will gradually decrease your net income over time.

Again, let’s consider the same example: the last inventory unit C, costs $18, and the order was for 5 units. So, the cost of goods sold under LIFO would be $18x5 = $90

Disclaimer: In most countries, the use of LIFO is prohibited by International Financial Reporting Standards (IFRS). Although it’s banned by IFRS, LIFO, or "last in, first out," is still in practice in the US. This is because it’s still permitted under the generally accepted accounting standards (GAAP).

Weighted Average Cost Method

As the name suggests, the cost of goods sold is calculated by taking the average price of all inventory in stock, regardless of when they were purchased. So, it is possible to avoid COGS being significantly impacted by the high costs of one or more purchases.

Not only that, but this also mitigates the impact of large ad hoc expenditures since it uses your average unit cost during that time.

So, the formula for calculating the weighted cost average would be the total cost of inventory purchased divided by the total number of inventory units.

Special Identification Method

This method yields the most precise unit cost as it tracks each unique item in stock from the time it arrives until it is sold. Using this approach, a company can pinpoint the particular item sold as well as its exact price. Realistically, large firms can’t use this strategy but startups and small enterprises can do this to keep up with tracking every item in inventory.

No matter what method you choose for calculating your cost of goods sold, it’s important to stick to it as this will provide you with the most accurate picture of your business’ financial performance.

Best Practices for Cost of Goods Sold

One of the most important steps in business accounting is figuring out the cost of goods sold accurately. This allows you to understand whether your business is profitable at all. So to help you, we’ve come up with some best practices you can follow:

  • Maintain and monitor supplier relationships: Any change in supplier prices will impact your COGS. So, when you routinely monitor prices, you can anticipate the changes these effects could have on your cost structure. This is especially crucial as maintaining profitability may require making timely changes to source choices or pricing strategies. 

    If you develop a long-term partnership with your supplier, you can negotiate and reduce the cost of inventory, which can increase your profit margin as well.
  • Categorize your COGS: It’s important that you don’t just lump all your inventory together as one chunk when doing your calculations. Take time to separate your units into their specific categories and then perform individual calculations for each.

    This makes it easier to see how different products affect the bottom line so you can decide which categories yield a reasonable profit margin.
  • Perform frequent audits: While monitoring COGS is crucial, you should pay much more attention to your gross margin (GM). You can find and fix irregularities early by routinely checking on inventory and financial records. So, even if your COGS is low or zero, you can find out what went wrong with your inventory.
  • Improve inventory efficiency: You should ensure that all your inventory is used up properly and it’s being utilized in sending the product to your customer. You can set up checkpoints to see how the cost of goods sold is faring with your revenue.

    There are also opportunities to bring in AI software that can help in your manufacturing process. McKinsey reported that 66%of manufacturers experienced an increase in revenue after automating processes with AI.

Lastly, your focus should always be on facilitating accurate financial analysis and sound decision-making. So, keep in mind that all the paperwork and reporting should follow accepted accounting standards.

Stay on Top of Your Ecommerce Metrics and Increase Your Profit Margins

For an ecommerce business hoping to maximize profits and financial performance, it is imperative to comprehend and handle the cost of goods sold (COGS) well. You can also improve upon setting up pricing tactics, inventory management techniques, and general operational procedures.

By accurately doing your COGS calculations, you can make better decisions while concentrating on what counts: providing your clients with outstanding goods and services. However, cost of goods sold isn’t the only metric you need to focus on, there are many others you should be looking at.

If you want to learn more about ecommerce metrics, strategies, tips and tricks, then look no further. Head to Whop.com and explore our ecommerce category to find everything you need: be it advice, tools, or resources.

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