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The Essential Guide to Understanding COGS Accounting for E-Commerce: Part 1

Cost of Goods Sold Basics. | © Wix Media.
Cost of Goods Sold Basics. | © Wix Media.

Cost of Goods Sold or "COGS" is the backbone of financial insight for businesses, specifying the direct costs involved in turning raw materials into revenue-generating products. This guide navigates the fundamental aspects of COGS, breaking down its significance and impact on financial strategies.

Understanding COGS: The Essentials

COGS represents the sum of direct costs essential in the production of goods ready for sale. For instance, in a shoe-selling venture, COGS covers:

  • Raw materials for shoe production

  • Shipping costs of materials

  • Production equipment expenses

  • Labor costs for production

  • Packaging for shipping (excluding customer shipping costs)

COGS in the Financial Landscape

COGS is presented on the income statement below revenues; the net of COGS and revenues equals gross margin, a metric often discussed ad nauseum in financial statement analysis. Besides accounting, these discussions often involve operations, procurement, supply chain, and sales teams because of the significant impact of COGS on a company's performance. Questions about how to maximize revenue or generate more cash center around COGS analysis.

The debits and credits of COGS. | © Wix Media.
The debits and credits of COGS. | © Wix Media.

Cost of Goods Sold Example

A company wanting to improve its margin will look to the procurement team to negotiate more favorable terms with vendors to realize cash savings. A controller may inquire with supply chain personnel about the timing of shipping orders to customers, which impacts COGS.

COGS is recorded in the same period as the revenue that it helped generate, in accordance with the matching principle and accrual basis of accounting. Doing so ensures accurate financial reporting and analysis. Suppose the shoe company from above sold a pair of shoes in June for $100. The total cost of producing the shoes is $60. The company will record the following journal entries in June:

Accounting: The Journal Entries

DR Cash 100

CR Revenue 100

To record sales revenue from shoes

DR Cost of Goods Sold 60

CR Inventory 60

To record COGS for shoe revenue

The income statement items from the journal entries, revenue and Cost of Goods Sold, net to $40 or a 40% gross margin. Based on this transaction, a Controller can tell the story of what's happening in the business. The commentary on performance would include something like,

"It costs us $60 to make $100. While our margin is OK for our industry, our competitors are outperforming us with 50+% margins  on similar products. So we know that consumer demand is there we need to find out how to improve our margins - with a combination of increased marketing efforts and shifting our product mix toward pushing higher-margin products. We're getting better rates from our vendors so let's also see about promoting the newer arrivals first so that we can sell the products with the lower cost first (assuming a FIFO inventory method). Let's get with marketing about sales campaigns and chat with supply chain to make sure we can handle the added shipping volume without excessive delays."

Communication is Key

It’s important to communicate with the parties involved in the sales process. Imagine a company with hundreds and thousands of transactions like this one and the many variables (shipping delays, returns, missing vendor invoices) that could impact COGS. While this is a basic story, it's important for companies to consider all costs involved in the revenue-generating process. COGS can become complicated if accounting staff (1) isn't knowledgeable about accounting concepts or (2) hasn't included all associated costs in the COGS calculation. Even more complications arise when prior period COGS are erroneously carried into a period outside of the one when the revenue was earned. This is where, again, the accounting knowledge is key as the staff must accrue (or estimate) COGS when actuals are unknown to align with the matching of revenues and expenses. 

Accounting for COGS. | © Nikki Winston, CPA
Accounting for COGS. | © Nikki Winston, CPA

COGS vs. Operating Expenses

An important distinction to note is the difference between COGS and operating expenses (commonly referred to as OpEx). Going back to the shoe company example, while the factory machinery is part of COGS, the electricity, factory supervisor's salary, and rent are not. While these costs are incurred to generate revenue, they are indirect costs that don't involve the product itself. Operating expenses also include salaries of office personnel, travel, office supplies and contract labor, to name a few. OpEx is presented below COGS in the income statement and the net of gross margin and operating expenses is called operating income.

COGS in Financial Strategy

Cost of Goods Sold is one of the most discussed and scrutinized metrics in finance. It provides insight into a company’s core with visibility of the efforts and costs required to generate revenue. Benchmarking against prior performance or competitive analysis tells a company how well (or not) they’re performing, and leads to larger discussions about pricing, efficiency, and business strategy.

Understanding COGS is not just a financial exercise but a strategic imperative for businesses aiming to navigate the intricate landscape of revenue generation. It's a journey into the core of financial performance and health, where numbers tell a story of costs, efficiency, and strategic decisions.

Unlock a wealth of expertise by exploring more of my content covering small business accounting, entrepreneurship, career insights, personal finance, and the realities of motherhood. For a deeper dive into these topics, visit the Writing content page. Connect with me on LinkedIn or submit your writing request below.

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