Is Your COGS Accounting Off?
When you operate in the eCommerce landscape, you will notice that accrual accounting better serves your business. This is due to the unique situation of an eCommerce business that deals with shipping costs, Amazon fees, Amazon Deposit, Inventory in transit, or Inventory Deposit. An accrual basis will help line up the sales and the cost of goods sold to approximate the most accurate margins.
This enables the seller to see if the margins are being consistent. If there is any inconsistency, the first place you want to look at is the Cost of Goods Sold (COGS), after all, a higher COGS results in lower margins.
The question now is, how do you know if your COGS is properly calculated? Is there something off about your COGS?
Cost of Goods Sold is the total cost incurred by a business in the production of goods or services that were purchased by the customer during the year. It is based on costs directly utilized in producing revenue. The basic formula for the COGS is computed as such:
Cost of Goods Sold = Beginning Inventory + Additional Inventory – Ending Inventory
The COGS is important because it plays a big role in determining company profitability and plays a factor in calculating your taxable income.
There are several things that the COGS can tell you. It can help measure operational efficiency by identifying which production is increasing the costs.
You could also use the COGS ratio to determine the percentage of sales revenue used by a business to pay for expenses that vary directly with sales. It is computed:
COGS ratio = COGS / Net Sales x 100
A low COGS ratio means the costs incurred are lower than the revenue produced. For example, a company with net sales of $70,000 and cost of goods sold of $50,000 for the year is calculated as follows:
COGS ratio = ($50,000 / $70,000) x 100
COGS ratio = 71.4%
Keep a look-out for warning signs
A straightforward way of spotting an issue is by comparing the COGS percentage to your margin percentage. Both these percentages should fairly remain consistent, having only a few points of difference. If they have significant deviation, it’s time to retrace your steps.
Usually, this variance could be a typical miscalculation of fees, shipping costs, or Amazon costs. However, it could also be a mistake in applying the accounting method. This means something is being added to your books that is inconsistent with your accounting method. Perhaps you are using an accrual-basis but you expensed a cost right after you purchased it, then you are mixing the use of the cash-basis accounting which creates huge discrepancies in your books.
Rising accounts receivable or inventory in relation to sales should also be watched for. Money tied up in inventory is sleeping money that cannot generate returns. While it is important to have sufficient inventory to meet consumer demands, you also don’t want a significant part of your revenue staying unsold in a warehouse.
How to fix your COGS
Some basic steps to take when attempting to fix your COGS include revisiting the eCommerce cash cycle.
If you wrongfully entered a transaction on a cash basis instead of the accrual, make sure to focus on tracking your inventory and how it affects sales. When you buy inventory, it shouldn’t be expensed right away, instead, it should be kept in an asset Inventory Account until they are sold.
Keep tabs on your Inventory Turnover. It is a financial ratio that measures how well a company generates sales from its inventory. It tells how many times a company sold and replaced inventory in a period of time.
Inventory turnover = COGS / Average Inventory
A low turnover is indicative of low sales and excessive inventory.
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For every business’s financial situation, different solutions can be generated. That’s why in Mehanna Advisors we aim to give custom-tailored guidance in dealing with your business finances.