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Most Shopify business owners face the challenge of narrow profit margins. It’s hard enough calculating your profitability accurately, taking into account – taxes, refunds, discounts, shipping, transaction costs, and employee costs.

Let alone tracking every cent in costs, so you can maintain profitability. Being overly-dependent on marketing channels, when your cost of goods and expenses are sky high is definitely a recipe for disaster.

Why should you read this article?

  • What exactly is included in COGS
  • Learn the different methods to accurately calculate COGS
  • How to reduce your COGS
  • What other costs you should take note of

Cost Of Goods Sold

If you don’t already know, COGS stands for Cost Of Goods Sold and it’s basically the value of the goods/inventory that you ship out to your customer when they make an order.

Many Shopify business owners keep an inventory of the products they sell and may calculate COGS inaccurately. We see sellers record COGS at the wrong time, not at the point of sale. Mistakes like that will skew your profit margin and affect your inventory management. How can you make the right business decisions with inaccurate numbers?

As the largest expense in any business, here are a few reasons why you should get serious with truly understanding COGs:

  • Incorrect COGs will mess up your taxes
  • Incorrect COGs will give you inaccurate profit margin
  • Inaccurate profit margins will affect your ability to run your business
  • Every decision made on ad spend, pricing, inventory management, and more are affected by COGS and profit margin.

Most Shopify brand owners are re-sellers with outsourced manufacturing and incur additional costs in their COGS numbers such as shipping, insurance, handling customs, and duties fees.

It is crucial to add these additional costs to get the “landed cost”, so you can have an overarching view of your actual COGS for each product you sell.

One common mistake that happens more frequently than you think is when recording COGS on the books, business owners expense the purchase of the inventory as COGS at the time of purchase. Inventory is sold over time and not right away. With this mistake, you are unable to account for the expense associated with the sale of products in the subsequent months. And with that, comes inaccurate profit margins.

To get accurate margins, all inventory purchases are only recorded in the books when the product is sold. That way, you can see the proper margins for sale for the month.

Here’s what a correct COGS recording looks like

Learn the different methods to accurately calculate COGS

Now that we have a clear understanding of COGS and how to properly record them in the books, let’s move on to calculating them.

There are four methods for calculating COGS for an inventory

  1. Specific identification
  2. Weighted average
  3. First-in, first-out (FIFO)
  4. Last-in, first-out (LIFO)

Specific identification

The specific identification method involves attaching the actual cost to an individual product. Let’s say product 1 is $2000, product 2 is $3000 and product 3 is $3500. When you sell product 2, your cost of goods sold on that is $3000. This method is too expensive to use for inventory items that have common characteristics, such as bushels of wheat, gallons of paint, or auto tires. They’re best for uniquely identifiable products.

Example: custom homes, automobile dealers, real estate, paintings, antiques.

Weighted Average

The weighted average method is best suited when your inventory consists of mass-produced products that are basically the same. Unlike other methods, this method uses the cost of the inventory as a whole, and are weighted by the number of units.

Consider you made these inventory purchases for the month of January:

  • 200 units at $8 per unit
  • 500 units at $6 per unit
  • 100 units at $10 per unit

The total inventory costs for the month of January will be calculated as follows- 200 x 8 + 500 x 6 + 100 x 10 = $5600. The weighted average cost per unit would be $7(the total inventory costs ($5600) divided by the total number of units (800).

Consider the quantity of units sold for the month of January is 250 units.

To find the weight-average COGS, for the month of January, multiply the average weight costs ($7) by the number of units sold (250). The value is $1750.

Examples: toys, electrical products, bottles, books, literally anything that is mass-produced.

First-in, first-out (FIFO)

The concept of FIFO is simple. It’s an inventory control system in which the first items that you bought are the ones that leave first. The logic behind this is that, the items you received first are the items that are held the longest, and therefore closest to expiry. So, even if the employee took a different unit when making a sale, it is always considered that the first or oldest unit leaves first.

Like in the previous method, consider you made these inventory purchases for the month of January:

  • 200 units at $8 per unit
  • 500 units at $6 per unit
  • 100 units at $10 per unit

If the month of january had a quantity of 500 units sold, to find the COGS for that month, simply take the costs of the first 500 units that you bought, which in this case is $3400 (200 units x $8/unit + 300 units x $6/unit).

Examples: Good for products quick to spoil; canned food, vitamins, protein powder.

Last-in, first-out (LIFO)

LIFO is the opposite of FIFO. The last units bought are the first products to be sold and taken out of stock.

Like in the previous method, consider you made these inventory purchases for the month of January:

  • 200 units at $8 per unit
  • 500 units at $6 per unit
  • 100 units at $10 per unit

If the month of january had a quantity of 500 units sold, to find the COGS for that month, simply take the costs of the filast 500 units that you bought, which in this case is $3400 (100 units x $10/unit + 400 units x $6/unit).

Any business that faces rising cost can benefit from using this instead of the FIFO system – to take advantage of lower taxes.

Examples: Retailers or automobile dealerships

How to reduce your COGS

In any business, the quality of the product determines loyalty and customer satisfaction. Customers are the lifeline of any businesses thus, many have the philosophy to uphold quality, and under any circumstances, must not be breached. However, when it comes to cutting costs for goods, that can go all out the window.

Here, we’ll round up a few methods for Shopify store owners to reduce their COGS.

  1. Reduce Shipping Costs
  2. Cultivate Good Business Relations

Reduce Shipping Costs

Especially for ecommerce-focused retailers, shipping is a necessary expense. But there are ways you can minimize these costs.

Cultivate Good Business Relations

Have you been a loyal customer to your vendors or suppliers for years? Oftentimes, retailers can negotiate a new, lower rate for the same products. Bulk pricing could be an option, or the vendor can throw in free shipping.

For retailers purchasing through a third-party supplier, see if you can get straight to the manufacturer. This could yield better pricing and information about and access to their other products.