Understanding Inventory and Cost of Goods Sold (COGS) for Amazon Sellers

If you like this video, don't forget to subscribe to our channel for more ecommerce tips and tricks around accounting. Also here at LedgerGurus, we have an entire team that's just focused on inventory. So this is an area that we've gone really deep on, that we've understood, spent a lot of time fleshing out the complexities on. So hopefully our time and effort and pain spent in this area will help empower you to be more successful.

So the first thing I want to talk about with understanding COGS and inventory is that if you've ever watched any of my videos before, you know that I try to kind of make it approachable for the smaller ecommerce sellers that are still kind of on the smaller side of revenue and need to be spending their time building the momentum of their business and not spending a ton of time in accounting processes and practices. As they grow and as their business becomes more complex and as they're relying more on their financial information, I show them how to level up, so that you can start from here and then you can move up until you are doing it better ways in general. But we try to make it approachable and then show you the path for leveling up.

When it comes to inventory COGS, I feel a little differently about it. And the reason why is because inventory is such a key part of the success of the ecommerce business at every stage, no matter what level they're at, that setting yourself up to do things correctly really helps you from an operational perspective, mature in your operational maturity. And then it becomes easy to get the financial data that you want.

So I wanted to start with the picture of this girl, because this is how I feel about it. I'm like, oh no, no, no, no, you didn't handle it that way. Because inventory, I believe there's a very right and a very wrong way of going about it.

Why COGS accuracy drives gross profit

So the first thing I want to talk about is why inventory and cost of goods sold is so important to track correctly. So cost of goods sold, hopefully you already know what that means, but basically if you don't, I'll just define it for you really quick. Cost of goods sold is the cost of the product that you actually sold.

So this is the top part of your profit and loss statement here. If you've set it up correctly, you have sales, which is, you know, pretty self-explanatory. It's what you've sold. But directly underneath that is a very important expense category called cost of goods sold. Sales minus cost of goods sold gives you your gross profit. And this is really your margin on your product.

And the reason why you want to set your financials up this way and you want to track this data correctly is because this gross profit is the most important metric that you will watch as a product business. If your gross profit margin is going down, if your gross profit margin is going up, or if it's holding steady, this is the most important metric for you to be watching in order to manage the profitability of your business correctly.

And so as you can see, cost of goods sold is the most important expense. It is one of two categories, sales and cost of goods sold, that helps you get to this gross profit. And so if you're doing it wrong, you can really skew these results.

The rookie error and the like a boss method

So what do I mean when I say doing it wrong? So I'm going to show you what I call the default rookie error. And basically what I mean by that is, this is what people default to when they don't know how to handle accounting around inventory correctly. This is the go to method that people use, and basically what it is, is whenever they buy product, they expense it.

So here's an example of how this hits the financial statements. So here's the top part of the profit and loss, just like what I just showed you guys. We have income across the top, only this time we have it broken out across three months. So in this case, let's say in the month of January, I bought a bunch of product, had it shipped into my FBA warehouse, or whatever warehouse I was using, my 3PL or my own warehouse. Well, in the first month that that hits, I expense it all right away. So what we end up with is a $15,000 gross profit loss in the month of January.

And then we have February, March, they're like frolicking through the hills free of any cost of goods sold burden, right? So like January gets an unfair rap and February and March aren't carrying their weight. But what it really means is that you have no idea how your business is really doing. And you show this extreme volatility around gross profit, and you really have no idea how you're really doing on your margins, because you expense it all right away.

So when it's done correctly, this is what it should really look like. And I call this the like a boss method, because this method gives you so much better results. Now this method does require a lot more work around it, and I'm going to talk to you about all the things you need to do to set it up to be able to do it this way. But this method is the right way of doing it.

So in this case, we still have the same months, same revenue levels, January, February, March. Only this time we are expensing the cost of our product incrementally according to how it was actually sold. So in this first month, we had $15,000 in COGS, then 10,000, then 20,000.

So what you see here is you see that I have a consistent gross profit margin month to month to month. And I can see how I'm performing as a business, and I can see what my profitability really is. And I can make really good decisions with this method. With this method, I'm flying blind and I got no idea what's happening. And in this method, I'm like a boss. I can use my financials to make good decisions.

So in order to be able to use this method, though, like I said, it does require you to set things up in a thoughtful way operationally. So that's what I want to walk you through today, an overview on that.

How inventory moves through your books

So I want to skip to the end for just a second to help you understand what is happening to inventory. How am I able to expense it incrementally over time if I'm not expensing it right away? What does that look like?

So this is your balance sheet and this is your profit and loss. So inside your financial statements, hopefully you're familiar with where these statements are. Hopefully you're familiar with what they look like, where to find them. Hopefully you're looking at them on a regular basis.

So when you first buy inventory, instead of expensing it right away, which would hit your profit and loss, instead it becomes an asset to you on your balance sheet. Instead of expensing it through COGS, instead you code it to inventory where it sits as an asset, which it is, right? Like if you have a full warehouse full of inventory, that is an asset to you. You could go to the bank, you can say, I want to take out a loan, I'm offering my inventory as collateral, and they would give you a loan based on the value of your inventory.

So in this situation, this is what it looks like when we first buy inventory. You can see we have $300 worth of inventory on our balance sheet and we have nothing in COGS, because we haven't sold anything yet. So in the following month, you can see that what ends up, or not the following month, like when you sell this, let's say you sold some product, you basically take whatever the value of that product was. So in this case, I'm saying it was 50, and that inventory moves from inventory on the balance sheet as an expense through COGS incrementally as the product is sold.

So this is what it looks like. This is how it moves through your financial statements. And this is what the journal entry looks like, if you're doing this through journal entry form inside QuickBooks or Xero, whatever it is you're using. So it becomes a credit to inventory, which reduces inventory, and it becomes a debit to cost of goods sold. Okay, so this is what the end result is. So now let's go back and talk about how to get there.

Building a product cost catalog from a vendor bill

So this is what it looks like to move inventory through COGS. So in order to successfully manage COGS and the movement of inventory from inventory on your balance sheet through COGS as an expense on your P&L, you need to be able to track two things. You need to be tracking the quantity of your inventory, so how much you have of each SKU, and the value of that inventory by SKU. So what does it look like? How do I track the value of my inventory?

So this is where I'm talking about operational maturity, and how striving to handle cost of goods sold inventory correctly helps you level up maturity wise across the board with your operations.

So let's say I get this $5,000 bill from a vendor and maybe I was buying bikes. Okay, well normally, if I wasn't doing this correctly, I would just, you know, record the AP and I would just pay the vendor, and maybe that's the last I would think of it. But in this case, I want to give this bill a lot more time and attention, because this bill is a gold trough, golden trough, a gold chest, I don't know whatever you want to call it. It's a gold chest of information. Okay, because what it's really telling me is that I bought this many yellow bikes, I bought two of them, and this was my price. Pink cruisers, I bought two of them, this was my price. Red trikes, I bought eight of them, this was my price. This helps me see the value of each of my SKUs individually.

Now, in this case, I'm assuming that you're buying your product as a finished product from a vendor. You're either outsourcing manufacturing, or maybe you're a reseller, or maybe you're doing product arbitrage. But whatever it is, I'm assuming that you're buying a finished product and that becomes your cost of goods sold. We have a whole nother video on how to track your costs if you're actually manufacturing your own product, and how to understand what your costs are when you're building your product yourself. But in this case, I'm assuming you're buying a finished product from your vendor. So these same principles apply whether you are building it yourself or whether you're buying from a vendor. You basically want to be able to say when you're done, this is what I have, this is the quantity that I have of it, and this is what the value is associated with it.

So I'm going to take all this information that's in the bill and I'm going to build what I call a product cost catalog. So in this product cost catalog, I now see that I have two yellow bikes valued at 1000 each, pink cruisers valued at 500 each, red trikes. This is my quantity. This is the value of that quantity, okay.

So as your product comes in, as you buy more orders, as you buy more shipments, you are updating your product cost catalog. Now if you are ordering under circumstances where your products stay pretty stable, you're not really looking at landed cost, you can really just kind of establish a product cost catalog and look for, you know, reasons why it's going to change, and otherwise just leave it the way it is. But this is what a product cost catalog basically looks like.

We have a whole nother video that goes deep on product cost catalog and helps you understand how to really build a product cost catalog, how to update a product cost catalog, how to use your product cost catalog. But in this video, I need you to know that having a product cost catalog is a very important part of this process.

Tracking quantity with the inventory equation

Then the other thing that you need to know is that in order to then assign value to your inventory, you need to be looking at the quantity of that times the value of that.

So when we look at the quantity, most sellers, when we are initially talking to them and we're asking them if they're tracking their inventory, most of them say, yes, of course I'm tracking my inventory. But when they say they're tracking inventory, typically they're talking about that they're tracking the quantity of their inventory, because they need to know what quantity they have available to sell on their different channels. Otherwise they have sellouts, they have [unclear] customers, all that kind of stuff. But I need them to track not only the quantity, but also the value.

So here's one thing you need to understand about the quantity of inventory. The quantity of inventory is usually the easy part of all of this to track. And this is a simple like math equation. Now, you thought you'd never use algebra or anything like that, but here it is in your face. Sorry about that.

But we're going to start with some simple addition. Basically whatever I have in my beginning inventory, and then I add to that whatever I purchased in that time frame, and then I subtract from it everything that was sold. That gives me my ending inventory, right? So for example, if I start with 20 and then I add another 10 and then I sell five of them, then I'm going to have 25 left, right? So this is the way that inventory moves through your overall business.

But what we're really trying to get here is cost of goods sold. So in this case, beginning inventory is easy to see, purchases is usually easy to see, ending inventory is usually easy to see. So I'm going to swap this equation so that what we're solving for is COGS, which is the harder part. So in this case, I'm going to say beginning inventory plus purchases minus ending inventory equals COGS. And you see what I did there. That was actually a little algebra trick, but hopefully you guys all remember that and how that all works. Just trust me, this is good math.

So in this case, we start with 20 of them, we add 10. We found now that we have 25 left, which means that we sold five during this period of time. So this is a simple way to go about tracking inventory quantity, if you don't have some sort of system in place to kind of track it every time a sale happens or whatever else.

Like if you're selling on Amazon, which is what this video is really geared towards, if you go into FBA, you can see what your beginning inventory was. You can see what came in during the period of time. You can run a report showing you what your ending inventory is, and therefore you can see what was sold during that period of time. You can also run reports to see what was sold. But so this is the way that this would work.

Now remember I said COGS comes from saying, what was my quantity times what was my value? So in this case, I'm just going to take these [unclear] numbers we had. And now I'm going to assume that we have a product that only cost us $10.00 for each product. So in this case, 20 units times $10 gives us $200 in value. Same thing, 10 units times $10 gives us, et cetera. But you can see clearly what's happening here.

This being the real number that I'm trying to get to, which is cost of goods sold, because this number here is the number that moves from my balance sheet on to my profit and loss based on how many units I actually sold. So this is really what I'm trying to get to here, is how many of these units did I sell and what was the value that was assigned to each of those units, and that gives me a cost of goods sold.

FBA as product master and recap

So if you are selling on Amazon and you're using FBA, this whole process becomes a lot easier in many ways, because FBA becomes also what I call the product master.

So product cost catalog, which I mentioned earlier, is where you have all of your products and you're assigning cost to those products. But the product master is what basically says, this is the inventory that I have available, this is the movement of my inventory. People often use tools that are product masters. Most inventory tools nowadays also act as product masters. And what a product master does is it indicates to all the channels you're selling on how much inventory you have available.

But if you're only selling on Amazon and you're using FBA, then FBA itself becomes your product master. It becomes really easy, because you send all of your product to their warehouse. Then you can see exactly what they received. You can see exactly what they sold during that period of time. You can see exactly what they have left. Therefore, FBA and all of its reporting becomes your product master around this. It makes it very straightforward and easy.

So the Amazon reports is where you would get all this. We have a whole nother video on how to actually pull the reports and see the movement in inventory and calculate all of this all the way through. This video, it's just a general overview of how this works. We'll link to that video below, as well as the other videos that I mentioned in this video.

So again, let's circle back to the very end so you can see how all this comes together. Okay. So in this case we bought our product, and instead of expensing it right away through cost of goods sold, we would put the inventory onto the balance sheet. Then during this period of time we maintain both a product cost catalog, video below on how to maintain that. We also maintain a product master, video below on how to maintain that. And then we take that and we say quantity times value of what was sold during that period of time gives us cost of goods sold. In this case, we're saying $50.00 of that was sold, right. So we say $50 goes from inventory through over to the cost of goods sold. And this then becomes our expense that allows us to see our margins, see how our business is doing, operate from an informed place. And here's what the journal entry looks like.

So I hope this video was helpful. I hope that it gave you some good ideas on how to handle this. Some other resources we have available for you is we have a whole blog on ledgergurus.com that talks about all this sort of stuff. We also have our YouTube channel. Don't forget to subscribe below, because we talk about all the stuff. Our goal is really to empower you guys to make decisions, to move forward, to really understand what your business is doing, and to build your business with better numbers.