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Demystifying Inventory and COGS Accounting for eCommerce Sellers

Most eCommerce small business owners have encountered their fair share of accounting mysteries, especially with inventory and COGS. It’s that pivotal moment when they realize the numbers on the spreadsheet aren’t telling the real story about their profits, sales, tax liability, or any number of critical business factors.

That’s why among the many hats accountants wear, detective is one of them. Problems can be embedded in the most minute of details, and uncovering the facts can take Sherlock-level skills. 

One area we want to highlight is with Inventory and Cost of Goods Sold (COGS). This is a vital area for eCommerce sellers to get the numbers right. After all, you’ve got to know what’s in your inventory (your goods) AND you’ve got to know the TRUE COST of those goods to you–which is your COGS. Miscalculations, especially regarding the COGS, can do some serious damage to your profit margins and leave you making important business decisions–like, can I afford more inventory?–in the dark.

Did you know one of the biggest mistakes eCommerce sellers make is recording their COGS at the time of purchasing the goods instead of waiting until they sell it? It’s true. A well-intentioned but highly problematic practice, calculating COGS at the wrong time is one of those seemingly small, but critically important details for making business decisions. You can read more about our explanation here and see some basic examples of how this problem impacts your profit margins. 

Cost and Count

So, how does a small business owner carry out accurate accounting for Inventory and COGS? First, you have to start with the basics–you’ve got to understand what represents “cost” (to you) and “count” of your inventory. While we’d like to say, “It’s elementary, my dear Watson!” We know only smug Sherlocks could say that with conviction, which is not us. Truthfully, it’s not as simple as doing math calculations; there is some context for understanding cost and count, which all depends on the complexity of your business. Let’s dive in… you can also watch our accompanying video explaining these concepts here.

First, COST. Cost is not the same thing as what you spend when you purchase goods to sell. It is more contextual. In addition to purchase cost, true cost also includes everything you spend to get your goods from your supplier (or produce it in-house, if that’s your business) and to the warehouse for your customer. Cost often includes factors such as purchase costs, freight, tariffs, inbound shipping, and packaging and labels.

Next, COUNT. Count boils down to the number of units of a given product/good (same thing as the SKU) you have on hand. Your count is always a quantity. 

Now that we’ve gone over the key terms, let’s look at actually calculating Inventory and COGS.

Calculating Inventory

Completing an accurate calculation of your inventory requires knowing four things:

  • Your last inventory number (beginning inventory)
  • The inventory you’ve received (which may be tracked via your warehouse staff or through invoices)
  • The inventory you’ve sold (comes from sales records)
  • Any inventory fluctuations not tied to sales, such as gifts or discarding bad product (known inventory happenings).

Here’s the basic formula for getting an accurate picture of your Inventory and which you can obtain through what’s called a Quantity Reconciliation Sheet:

Beginning Inventory + Received Inventory – Sold Inventory – Known Inventory Happenings = Calculated Inventory 

As a best business practice, we recommend periodically performing self-audits and comparing the Calculated Inventory to the Actual Inventory on hand (i.e., do a physical count). This will shed light on any discrepancies that may exist. If those discrepancies are significant, we recommend bringing in an accounting Sherlock to drill down into your records and investigate the story. All of this will help you in understanding how to optimize your Inventory Turnover which is key to managing your biggest business asset–your Inventory.

Calculating COGS

Once the leg work is complete of calculating your Inventory and also the cost per unit of what’s in your Inventory, you’re ready to calculate COGS. The formula is actually pretty straightforward:

Quantity Sold x Cost per unit = COGS

Remember, COGS is the number that will tell the REAL STORY of your business. It’s much more useful than just knowing the cash used to purchase goods. 

Another really helpful figure to understand is your Physical Inventory Valuation. This is the number that shows the value of the goods you have on hand, and here’s how it’s calculated:

Cost per unit x Total # of units on hand = Total value on hand

As another best business practice, we recommend you calculate this figure at least annually. Doing so quarterly, or even monthly, of course is even better as it’s another piece of information to help you make business decisions. But for starters, take our advice, and plug this into the calendar as a regular thing you do every year.

If you’ve followed along with the math exercises, you may be ready to see where your eCommerce business stands with Inventory and COGS. Well, if the answer is yes, we’ve got you covered! We put together this free template to help you get started! You can download it here.

Reasons to seek an expert

In calculating Inventory and COGS, you may come across a mystery that takes extra sleuthing to get accurate numbers. You may find yourself saying, well I just don’t know what I don’t know! In these instances, you’re going to be happy to have a Sherlock in your corner. Especially when those discrepancies are getting into the tens of thousands of dollars (or perhaps more?!). Here’s some common reasons eCommerce seller may want to bring in a consulting expert: 

  • If you are involved in the manufacturing side of your goods–calculating the count can be complex as the manufacturing process has A LOT of pieces.
  • You have fluctuating costs.
  • There is a significant time delay between purchase and receipt.
  • Other unexplained discrepancies that are not “elementary.”

Whether it’s due to one of these reasons or you simply want to leave the detective work to someone else, we’d love to solve the mystery for you. It’s what we do best, and in fact, it’s what makes us tick! You can reach out to us here to get a consultation lined up. And if you do, we promise we’ll leave the cryptic questions and eccentric antics at 221B Baker Street.