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. When using certain inventory valuation methods, such as FIFO, COGS includes the actual costs of the oldest inventory, providing a more accurate reflection of inventory costs and the cost of goods sold.

It includes the costs of:

• Factory labor
• Raw materials (includes raw materials as a key component)
• Machinery and tools
• Packaging
• Freight in
• Custom duties

These are the direct costs attributable to producing goods, and direct production costs such as materials and labor are essential for accurate COGS calculation.

What it doesn’t include:

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

COGS does not include indirect costs and other costs, such as rent and utilities, which are not directly tied to production.

COGS helps you understand your gross margins, and ultimately, your company's profitability. For commerce businesses, COGS is a key metric to assess financial health and make informed decisions about pricing, production, and operations. Understanding the key components of COGS, including the manufacturing process, is crucial for business success. Knowing your COGS 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.

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Introduction to COGS

The Cost of Goods Sold (COGS) is a fundamental financial metric that captures all the direct costs involved in producing and selling your goods or services within a specific accounting period. By accurately calculating COGS, businesses can determine their gross profit—a key indicator of financial health and operational efficiency. COGS includes direct costs such as raw materials, direct labor, and manufacturing overhead costs, but excludes indirect expenses like administrative expenses and operating expenses. Understanding your cost of goods sold is essential for developing effective pricing strategies, managing production costs, and making informed decisions that impact your company’s overall profitability. By keeping a close eye on COGS, you can ensure your business remains competitive and financially sound.

Components of COGS

COGS is made up of all the direct costs that go into producing and selling your goods or services. The main components include:

• Direct materials: These are the raw materials used in the production process, forming the foundation of your finished products.
• Direct labor: This covers the direct labor expenses for employees who are actively involved in the production process, such as assembly line workers or machine operators.
• Manufacturing overhead costs: These are the costs associated with running your manufacturing facility, including indirect labor, utilities, and equipment depreciation.
• Other direct costs: Any additional direct costs tied to the production and sale of goods, such as shipping and handling, are also included.

By accurately tracking all the direct costs that make up COGS, businesses gain valuable insights into their operational efficiency and financial health, allowing for better decision-making and improved profitability.

Direct Costs and COGS

Direct costs are the expenses that can be directly traced to the production and sale of your goods or services. These costs are a core part of COGS and play a crucial role in calculating your gross profit. Direct costs include:

• Raw materials: The essential materials required for the production process.
• Direct labor costs: Wages and benefits paid to employees who are directly involved in manufacturing your products.
• Direct expenses incurred: Any other direct expenses, such as specific production supplies or packaging, that are necessary to bring your goods to market.

By understanding and managing direct costs, businesses can streamline their production process, minimize waste, and ultimately boost their overall profitability.

COGS Calculator Guide for DTCs

As a DTC business, the quickest COGS calculator you need is the following formula that gets you strategizing for the the financial year

COGS = Beginning inventory value + Total purchases made after the previous period - Remaining inventory at the end

To calculate cost using this formula, start with your beginning inventory from the previous period, add all total purchases made during the current period, and subtract your ending inventory.

While this DIY COGS calculator strategy makes it look easy (and quick), in reality, it’s a painstaking and time-consuming process to do it manually. Keeping track of inventory purchases to every dollar throughout the year is difficult. A goods sold calculator can simplify this process by automating the inputs and calculations for you.

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. Peel also offers a free cost calculator for COGS, making it easy and accessible for anyone to get started.

COGS Calculation Formula

To calculate your cost of goods sold, use the following formula:

COGS = Beginning Inventory + Inventory Purchases - Ending Inventory

This formula takes into account your starting inventory at the beginning of the accounting period, adds any additional inventory purchases made during the period, and subtracts the ending inventory that remains unsold. By applying this COGS formula, you can accurately determine your gross profit and assess your company’s performance on financial statements. Understanding your gross margin through this calculation is essential for evaluating profitability and making informed business decisions.

Average Cost Method

The average cost method is a practical approach for calculating COGS, especially for businesses with fluctuating inventory costs or those selling similar products at varying prices. With this method, you determine the average cost of all inventory purchased during the accounting period. To do this, add up the total cost of inventory purchases, divide by the total number of units purchased, and then multiply by the number of units sold. This technique simplifies the cogs calculation and provides a clear view of your true cost of goods sold. The average cost method is particularly useful for optimizing inventory management, reducing excess inventory, and ensuring you have an accurate understanding of your inventory costs and overall profitability.

Cost of Goods Sold (COGS) Example

Let’s take a snacks company for example. Suppose this business sells snacks and incurs costs for producing goods. They start the year 2025 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 unsold inventory worth $20,000.

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

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

These figures are reported on the company's income statement, where COGS is deducted from total revenue to determine gross profit.

Let’s consider the sales revenue (or total revenue) they generate in the year 2025 is $150,000. So, their gross profit margin will be:

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

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

COGS also impacts taxable income and the company's profitability, as higher COGS reduces taxable income and net profit.

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. Optimizing inventory management and using demand forecasting can help reduce COGS by preventing over-ordering and aligning inventory with actual customer demand. Here are three ways you can reduce your costs:

Reducing your COGS not only improves profitability but also has a positive impact on cash flow, allowing you to better manage expenses and maintain financial health. Additionally, lowering COGS gives you more flexibility in your pricing strategy, helping you stay competitive while maximizing margins.

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 use demand forecasting to accurately predict your future sales based on industry trends and your past year’s sales. Demand forecasting helps you optimize inventory management, so you can prevent over-ordering and avoid excess inventory. 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.

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