Accounting for Inventory Purchases; Ecommerce Accounting

Correctly accounting for inventory purchases (COGS)During the Utah Crowdfunding Summit, our CEO Brittany pointed out one of the biggest mistakes made by ecommerce companies and businesses in general. How we record the cost of our products or Costs of Goods Sold (COGS) when accounting for inventory purchases.

(To view the full presentation click here). 

COGS; A Misunderstood Number 

Various things in life are misunderstood. Such as people thinking you can see the great Wall of China from space, for instance. Or that Bulls are enraged by the color red when in fact they are colorblind. And lastly, that Twinkies last forever when in reality they only have a shelf life of 45 days. Ultimately, commonly misunderstood facts such as these could leave you disappointed in space, feeling a little nervous in a bull-pen, and with a little bit of unexpected indigestion. 

Costs of Goods Sold, consequently, is one of the most important numbers for ecommerce businesses to understand (more on this here). In regards to accounting for inventory purchases, cost of goods sold is a very misunderstood number. Similarly, the consequences of misunderstanding it are akin to a mix of space disappointment, nervous bull-pen energy, and a very bad case of indigestion.  

In the same vein, one of the common misconceptions’ ecommerce companies make regarding COGS, is that cash flow and profitability are one and the same; they aren’t. Moreover, companies are tracking their cash flow and lose sight of the importance of tracking their profitability. Consequently, many companies may be unaware that their Cost of Goods Sold is incorrect.  

Look into other common accounting mistakes here.

Accounting for Inventory Purchases:  

Normally, when you first start out and purchase inventory, you put it in a warehouse or with your 3PL. If this is the case, firstly, you will be shelling out a large initial investment for your Inventory. Secondly, you may not see all the sales from that inventory for a while.  

Recording the cost of their inventory at the time of purchase instead of waiting until they sell it is one of the biggest mistake companies make. Moreover, doing this creates irregularities in their income statement and makes them appear a risky investment. Therefore, this makes it harder for them to potentially exit. 

Cost of Goods Sold Example 

Below is an example of how recording cost of goods sold correctly can drastically change those key numbers that will in turn, influence the appearance of your company’s profitability. 

Here we view the income statement for “Wooden It Be Lovely Company”.  

Example #1 Incorrect COGS  
Wooden It Be Lovely Company       
  Month 1  Month 2  Month 3 
Product Sales  $15,900  $15,900  $15,900 
Cost of Goods Sold  -$30,000  $0  $0 
Gross Profit  -$14,100  $15,900  $15,900 
       
Advertising   -$45  -$45  -$45 
SEO  -$10  -$10  -$10 
Platform Fees  -$50  -$50  -$50 
Salaries/Payments  -$600  -$600  -$600 
Software Fees  -$45  -$45  -$45 
Utilities and Access  -$85  -$85  -$85 
Insurance  -$40  -$40  -$40 
       
Operating Income   -$14,975  $15,025  $15,025 
Interest  -$25  -$25  -$25 
Taxes  $0  -$150  -$150 
Net Income  -$15,000  $14,850  $14,850 

Example #1, for instance, shows that the company recorded their inventory costs the same month they purchased the inventory instead of waiting until they sold the inventory to record the costs. As a result, the company recorded a -$15,000 loss in the first month. However, over the next few months they sold the inventory but didn’t show any expense against those sales. Making their income number appear larger than it should be. In addition, it impairs the ability f they have to make informed decisions. For instance, decisions such as: can I hire a new person? What can I afford in marketing spend? Do I have the funds necessary to open a new or more expensive office? It skews the ability to measure profit at all! 

Unlike Example #1 the income statement in Example #2 shows their correct income numbers. In other words, they recorded their product costs at the time of sale. 

Example #2 Correct COGS
Wooden It Be Lovely Company       
  Month 1  Month 2  Month 3 
Product Sales  $15,900  $15,900  $15,900 
Cost of Goods Sold  -$10,000  -$10,000  -$10,000 
Gross Profit  $5,900  $5,900  $5,900 
       
Advertising   -$45  -$45  -$45 
SEO  -$10  -$10  -$10 
Platform Fees  -$50  -$50  -$50 
Salaries/Payments  -$600  -$600  -$600 
Software Fees  -$45  -$45  -$45 
Utilities and Access  -$85  -$85  -$85 
Insurance  -$40  -$40  -$40 
       
Operating Income   $5,025  $5,025  $5,025 
Interest  -$25  -$25  -$25 
Taxes  $0  $0  $0 
Net Income  $5,000  $5,000  $5,000 

Although they are the same exact company, a prospective buyer would find the second company to be a more attractive investment. In other words, income numbers for the second income statement appear more stable.  In this scenario cost of goods sold is expensed over time incrementally in alignment with the product that is being sold.  

If you have been doing things as shown in the first scenario, then don’t despair! Firstly, strategies such as this can be useful because it is a good indicator of cash coming in and cash going out. Secondly, businesses experience the cash cycle in a very significant way and this helps us see those cycles clearly. Moreover, ecommerce businesses are often taking advantage of seasonal sales or buying in bulk to cut down on shipping rates to reduce their landed costs. As a result, they are storing inventory over time and so they have a long drawn out cash cycle. However, although it shows us the movement of cash, it completely skews profitability. Certainly, this technique should only be used for cash-flow analysis.

In conclusion, the second scenario is scaling at a more predictable rate and therefore it is a safer bet. 

Click here for more information on managing your inventory.  

Accounting for Inventory: Journal Entries 

Additionally, understanding the behind-the-scenes accounting helps us better see what is actually happening when we buy and sell inventory. Let’s take a look at the journal entries that are made for both the purchase and sale of inventory: 

Purchases (Cash and on Account)  
  Debit  Credit  Account 
Inventory $XXX    Asset
Accounts Payable    $XXX  Liability

 

  Debit  Credit  Account 
Inventory $XXX    Asset 
Cash                               $XXX  Asset
Sales  (Recognizing COGS and Revenue)                
  Debit  Credit  Account 
COGS  $XXX    Expense 
Inventory                     $XXX  Asset 

 

  Debit  Credit  Account 
Cash  $XXX    Asset 
Sales Revenue             $XXX  Income 

Above all, these entries make it easy to see that you recognize cost of goods sold and sales revenue at the same time. For instance, the first entries upon purchase of your inventory don’t list either cost of goods sold or sales revenue. 

For sales tax journal entries click here 

In conclusion, be careful as to WHEN you include cost of goods sold. Furthermore, when accounting for inventory purchases, only include the expense on your income statement as you sell the product the expense relates to! Example #1 and Example #2 above show the exact same company but with the accounting done incorrectly and correctly. Likewise, doing it wrong not only impairs your ability to measure the profitability of your company and make informed decisions, but as a result, it also impairs the ability of others to see the true value of your company! What is the key take-away from this article? Above all, remember to correctly record your COGS and don’t eat expired Twinkies. You’re welcome!