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Ecommerce metrics

Cost of Goods Sold (COGS) — Ecommerce metric refresher

Vallabh Daga
January 19, 2021
6
mins read

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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)

The following illustration shows the cost of goods sold (COGS) formula:

Cost of goods sold (COGS) formula

  • Starting inventory: This is the total cost of inventory remaining from the previous period.
  • Purchases made during the period: This is the total cost of products you purchased or manufactured during the period.
  • Ending inventory: This is the total cost of inventory you have leftover at the end of period.

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

Why should ecommerce businesses calculate cost of goods sold (COGS)?

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:

  1. To keep track of all your expenses — and understand the gross profit margins of your business
  2. Cost of goods sold (COGS) is an expense line item in your company's Profit and Loss (P&L) statement, therefore the calculation of cost of goods sold (COGS) is important for government compliance and taxation purposes.
  3. To identify excess expenditures and find avenues for cost-cutting.
  4. To make product pricing decisions: Only if you know the cost of goods sold (COGS), you can set appropriate product prices that leave you with a healthy profit margin. For example, if an ecommerce company's cost of goods sold (COGS) is INR 10,000, then they would need to price the product higher than INR 10,000 to turn a profit.

How to reduce cost of goods sold (COGS)?

1. Buy in bulk and receive discounts

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.

2. Substitute existing materials with cost-effective alternatives

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.

3. Find alternate suppliers

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.

4. Incorporate automation

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.

5. Offshore manufacturing

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.

Bottom line

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.

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