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The Essential Guide to Understanding COGS Accounting for E-Commerce: Part 2

COGS Accounting for ecommerce businesses. | © Wix Media
COGS Accounting for ecommerce businesses. | © Wix Media

In the dynamic world of e-commerce, where revenue models often involve intricate relationships with external parties, the Cost of Goods Sold (COGS) plays a pivotal role. This is especially evident in scenarios such as dropshipping, where maintaining inventory isn't a burden carried by the e-commerce company directly. Instead, third-party fulfillment companies handle the intricate process of sourcing and shipping products on behalf of the e-commerce entity.

Why Understanding COGS is Important for e-Commerce Businesses

Many e-commerce companies have revenue models that involve other parties. In the case of dropshipping, an e-commerce company doesn’t maintain its inventory, so it relies on external vendors to fulfill customer orders. This model has become preferred by many retailers who don’t wish to bog down their balance sheet with inventory that quickly becomes obsolete.

While the customer does business directly with the e-commerce company, it’s the 3rd-party fulfillment company who will source and ship products to customers on behalf of the e-commerce company.

The Revenue Recognition Challenge for e-Commerce Businesses

One of the critical challenges faced by e-commerce companies revolves around the loss of control over shipment timing once the fulfillment phase begins. ASC 606 requires companies to apply the 5-step revenue recognition principle to transactions with customers and many companies’ obligations to customers is met once the order is shipped. Knowing when a vendor has shipped an order is key to e-commerce companies since no revenue can be recognized until that happens.

This is where the supply chain team plays an important role. Supply chain is the liaison between the company and its various suppliers. Sources like dashboards, real-time processing, and integration with vendors’ systems allow e-commerce companies some visibility into where customers orders stand. This is important because it directly impacts the timing of revenue and accurate financial reporting.

How an eCommerce Businesses Benefit from COGS Visibility

  • Flexibility to negotiate payment terms and incentives with vendors if you have high volume. Knowing how much you spend on supplies and asking vendors for volume discounts not only improve your margins but enhance your cash flow if your volume discount is a cash rebate.

  • Cash forecasting and budgeting figures are more accurate. Being able to slice and dice COGS into current vs. prior period amounts is key to accurate financial reporting. Monthly accruals and timing issues can skew margins and knowing what’s truly related to sales and what’s correcting prior period errors creates added reliability for budget and forecasting purposes.

  • Know where money is being spent. When COGS is not aligned with expectations, it becomes everybody’s problem: accounting, supply chain, accounts payable, and sales. It’s a collective effort to tell the story of what happened with COGS. Did accounting miss an accrual or overaccrue expenses? Did finance or sales estimate the wrong product mix? Or is it a technology issue where systems aren’t syncing with vendor systems? COGS analysis forces these conversations to be had so that employees and management are aligned on the drivers behind COGS fluctuations.

Accounting, Systems, and Technology Challenges

Systems & technology are key. | © Wix Media
Systems & technology are key. | © Wix Media

Even companies with seemingly straightforward revenue models can face complications due to outdated, homegrown systems that struggle to meet current business needs. Additionally, the absence of proper integration can lead to duplicated efforts to ensure alignment between different systems.

The other technology challenge is having the right systems, except there’s no integration so there’s duplication work to make sure the systems always match. It’s important for companies to have robust technology stacks that provide real-time, ongoing communication internally and also externally with vendor systems.

COGS Accounting for e-Commerce Businesses: An Example with Journal Entries

When sales impact multiple periods - an order is placed on the 30th but not shipped until the 2nd of the following month, can the company’s systems interpret that hiccup in the revenue cycle or is human intervention required? In this case, while the company won’t recognize revenue until the product is shipped, they must accrue the revenue in the current period since it ships in a subsequent period with the following entry:

DR Accounts Receivable

CR Revenue

So that revenue and expenses are matched in the same period, COGS must also be accrued. This can be calculated as either a percentage of sales or based on historical costs of similar transactions. The offset is to inventory to represent the reduction of items available for sale.

DR Cost of Goods Sold

CR Inventory

There's a lot of emphasis on net income or the "bottom line" when decision-makers need to have an in-depth discussion about COGS. The Cost of Goods Sold tells you how much you had to spend for each dollar of revenue you've earned. Without this information it's difficult to make the right decisions to grow. Companies must make the appropriate investments in systems, talent, and processes so that COGS analysis adds value to the forecasting and strategic direction of the business.

Here's a list of questions often asked about this post and accounting for COGS in e-commerce businesses.

If you have a question or thoughts about this post, comment below.

Frequently Asked Questions: Accounting for COGS in e-Commerce Businesses

What is COGS, and why is it important in e-commerce accounting?

COGS stands for Cost of Goods Sold, and it's crucial in e-commerce accounting because it represents the direct costs associated with producing or purchasing the products you sell. This includes costs like manufacturing, shipping, and storage, and understanding it helps you calculate your gross profit accurately.

How do I calculate COGS for my e-commerce business?

To calculate COGS, start with your beginning inventory for the period, add purchases and production costs, and subtract ending inventory. The formula is: COGS = Beginning Inventory + Purchases/Production Costs - Ending Inventory.

Can you explain the difference between COGS and operating expenses in e-commerce accounting?

COGS represents the direct costs tied to producing or buying the products you sell, while operating expenses cover the general costs of running your business, like marketing, rent, and salaries. COGS is subtracted from revenue to calculate gross profit, whereas operating expenses are deducted from gross profit to determine net profit.

How often should I calculate COGS for my e-commerce business?

It's advisable to calculate COGS regularly, typically at the end of each accounting period, whether it's monthly, quarterly, or annually. This helps you track the cost of selling goods and monitor your business's profitability.

Are there different methods for valuing inventory in e-commerce accounting?

Yes, there are several methods, including FIFO (First-In, First-Out), LIFO (Last-In, First-Out), and weighted average. Each method has its advantages and can impact your financial statements differently.

How can I optimize my COGS to increase profitability in my e-commerce business?

To optimize COGS, you can negotiate better deals with suppliers, streamline your supply chain, and implement inventory management software. Reducing COGS can lead to higher gross profits and better overall financial health.

How can I use COGS analysis to make informed business decisions in e-commerce?

By regularly analyzing your COGS, you can identify trends, assess the profitability of specific products, and make informed decisions about pricing, inventory management, and product offerings.

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