Data Analytics

What is Cost of Goods Sold (COGS) & How to Calculate It

Ecommerce remains a competitive industry. To get ahead in the competition, merchants often have to win a cut-throat pricing war, which leaves them with low margins.

This makes tracking every penny important, from direct costs to gross margins. Without a savvy understanding of your numbers, you might fall prey to dwindling profits – even if your sales are increasing.

This is where the cost of goods sold (COGS) helps you.

COGS is the total cost you incur for the production of goods before it reaches your inventory. This means the cost of production and acquisition of goods is your COGS.

It includes the costs of:

  • Factory labor
  • Raw materials
  • Machinery and tools
  • Packaging
  • Freight in
  • Custom duties

What it doesn’t include:

  • Marketing costs
  • Overheads
  • Freight out
  • R&D cost
  • Operational cost
  • Indirect labor cost

COGS helps you understand your gross margins, and ultimately, your profitability. Understanding it will give you an idea of how much you can spend on marketing, how low you can price your products when needed, and if you’re ever heading towards a loss.

How to Calculate COGS

As a DTC business, you can calculate your COGS metric for an entire financial year with this simple COGS formula:

COGS = Beginning inventory value + Purchases during the period - Remaining inventory at the end

While this cost of goods sold formula makes it look easy (and quick) to calculate COGS, in reality, it’s a painstaking and time-consuming process to calculate it manually. Keeping track of inventory purchases to every dollar throughout the year is difficult.

The reason is, COGS is different from your total and landing costs. You have to manually take away all the operational and overhead costs. And if you get it even slightly wrong, all the other calculations will go haywire.

Automating the calculation gives you and your team the chance to think of the more important aspects of your business – strategizing to reduce the costs. This is what Peel helps you with. It takes away the heavy lifting of the manual COGS calculation process, so you can focus on taking actions that’ll add to your business.

Cost of Goods Sold (COGS) Example

Let’s take a snacks company for example. Suppose they start the year 2022 with snacks worth $10,000 in their inventory. Throughout the year, they make purchases of $80,000. At the end of the year, they’re left with goods worth $20,000.

So, their cost of goods sold (COGS) will be:

$10,000 + $80,000 - $20,000 = $70,000

Let’s consider the revenue they generate in the year 2022 is $150,000. So, their gross margin will be:

$150,000 - $70,000 = $80,000

If they had a higher COGS with either higher purchases throughout the year or more inventory at the end, their gross margin would’ve been affected.

Knowing what their margins are will allow them to reduce prices when needed or spend more on marketing. Without the COGS number, they risk diluting their margins, or worse, going into a loss.

3 Ways to Reduce COGS

Reducing your COGS will give you the opportunity to pour more money into other operations, like marketing. Here are three ways you can reduce your costs:

Automate processes

COGS mainly consists of labor costs and raw materials. You can’t reduce the cost of raw materials after reaching a minimum without reducing the quality. If you decrease quality to reduce costs, sales will be directly impacted, leading to loss.

The option left, then, is to reduce the cost of labor. You can do this easily by analyzing your manufacturing unit and seeing the parts that machines can do.

While there’s a huge upfront cost in setting up machines, they’ll prove to be cheaper in the long run.

If you have a supplier, ask them if they’re already automating parts of their processes. If not, this can be a negotiation point for you. Also, make sure you’re talking to a lot of suppliers before you finalize one.

Take your manufacturing offshore

“Made in the US” is a huge selling factor. But at what cost?

If your COGS is high and you’re surviving on low-profit margins, consider moving your manufacturing to low-cost sourcing countries. As long as the quality isn’t compromised, your sales won’t be affected. Many of the popular DTC and ecommerce brands have their manufacturing units in countries like China and Taiwan. Even a brand like Apple has taken its manufacturing offshore.

It’s not just the labor cost that’s reduced with offshore manufacturing. But every cost included, from raw materials to utility, is reduced when offshoring. Even after including the high shipping cost, in this case, your cost of goods sold will still be significantly lower when outsourcing.

But the drawback is again the upfront cost and the risks. So, you can only consider this strategy if you’ve been in the business for a while and are rapidly growing.

The issue of quality can also arise, which can crumble your sales. There can also be problems regarding the unethical labor conditions in such countries. As a result, you have to make sure you’re weighing in all the factors before you take your manufacturing overseas.

Forecast sales and buy in large quantities

Placing a large purchase order compared to frequent small orders is definitely cheaper. But is it really?

If you order in bulk but don’t sell at the same pace, you’ll have sitting inventory that’ll cost you storage and other overhead costs. You might also want to make changes in your product as you receive customer feedback – and with a large sitting inventory, it won’t be easy.

So, while it sounds easy to buy in bulk, it isn’t.

The solution is to accurately forecast your sales based on industry trends and your past year's sales. You need to have this data without errors, so doing it manually could be detrimental. Use the help of an AI-powered tool like Peel to make sure you get it right and order in larger quantities to receive discounts.

Calculating COGS with Peel

COGS is a significant part of your income statement that lets you operate efficiently in different areas of your business.

Manually calculating this important data not only eats up your time but also leaves room for error that can completely throw off your entire strategy.

Peel lets you automate your COGS calculation with complete accuracy. As a result, you have time to focus on reducing the costs and not getting tied up in months of inventory cost calculation.

Integrate Peel with your Shopify store today to increase your profits.