Key Performance Indicators (KPIs) are the metrics used to measure the performance of a business. Similarly, ecommerce metrics are the KPIs that can help online businesses evaluate their performance, set benchmarks, and take corrective measures to steer the business in the right direction.
In this ecommerce metric refresher, you will learn what is Cost of Goods Sold (COGS), how to calculate Cost of Goods Sold (COGS), why should businesses calculate Cost of Goods Sold (COGS), benefits of reducing Cost of Goods Sold (COGS), and the strategies to reduce Cost of Goods Sold (COGS).
Cost of Goods Sold (COGS) is an ecommerce metric that measures the total cost to produce or acquire the products you sell.
If an ecommerce store purchases inventory from a third party supplier, the cost of goods sold (COGS) is equal to the expense associated with obtaining that inventory.
If an ecommerce store manufactures its own inventory, the cost of goods sold (COGS) is equal to the cost of producing those products, like raw material and labour.
Here's a list of what's included and what's not included in cost of goods sold (COGS) for a women's apparel manufacturer
Included: The cost of fabrics, label, thread, tie-up waist, machinery and tools, labour for design and manufacturing
Not included: The cost of marketing costs, overheads and indirect labour (i.e employees not directly associated with production)
Note: The time period has to be defined by you — it could be monthly, quarterly, yearly, and so on.
Let's see how to calculate cost of goods sold (COGS) with an example,
Consider a business that wants to calculate COGS for the previous quarter.
Value of starting inventory at the beginning of the quarter = INR 2,00,000
Inventory manufactured over the course of the quarter = INR 1,50,000
Value of ending inventory when the quarter ended = INR 1,80,000
Therefore, cost of goods sold (COGS) = 2,00,000 + 1,50,000 - 1,80,000 = INR 1,70,000
The most basic use of cost of goods sold (COGS) for any business is to calculate gross profit. (Gross profit = Revenue - COGS)
Let's consider that the same business made INR 4,50,000 in revenue for the same quarter. Therefore, Gross profit = 4,50,000 - 1,70,000 = INR 2,80,000
Cost of goods sold (COGS) is bound with virtually every business aspect, so not getting it right can have serious consequences. A miscalculated cost of goods sold (COGS) can negatively affect pricing, purchasing, forecasting, and cash flow management. It can also result in booking an incorrect taxable income, leading to legal fines and penalties. There are many reasons for businesses to calculate cost of goods sold (COGS), such as:
If you purchase materials in large quantities, you will often get access to bulk discounts. You need to speak to your suppliers (either for inventory or raw material) and negotiate for the best price.
Products can be manufactured using a variety of different materials, depending on your requirements. With the advent of technology, newer materials are constantly being developed and older materials are constantly being improved — this means the materials market is highly volatile and the prices keep changing.
When considering switching your material, keep all the factors in mind. For example, substituting a material for a cheap alternative might result in an inferior quality product. Also, some materials may require different methods of manufacturing and so on. Ideally, your goal should be to find cost-effective alternatives which don't make you compromise on your product quality.
With a little bit of research, you will be able to find alternate suppliers of similar products or materials which you need. Determine the differentiating features of different suppliers and make an informed decision to choose the most cost-effective supplier.
Each activity or task that you can replace with a machine rather than a human significantly reduces your cost of goods sold. For instance, with machines, you don't need to worry about health insurance, fatigue, or inefficiencies.You need to proactively identify avenues where you can incorporate automation and reduce dependency on human resource. Incorporating automation can be expensive initially, however, it will help you save a lot of money in the long run.
This method is unconventional, but it is another way to reduce your cost of goods sold (COGS) if you manufacture your own products. You can outsource your manufacturing to a country where material and labour costs are cheaper than where you currently manufacture your products.
For example, China has become a popular offshoring destination for business owners due to the availability of cheap labour and materials.
Now that you know how to calculate the cost of goods sold (COGS) for your ecommerce business, you can find avenues to reduce your business costs and improve profit margins, file income tax impeccably and improve overall cash flow.