Crunching numbers isn’t everyone’s cup of tea—and that’s perfectly fine.
The financial side of an Amazon business can be a bit daunting, but it doesn’t have to be that way. Basic concepts like determining the cost of goods sold (COGS for short) or calculating your gross profit each month are easy to do; it all depends on how these things are taught.
Plus, increasing your financial savviness helps in cutting down taxes, saving money, and reinjecting it into your business!
Here’s everything you need to know about Amazon cost of goods sold—explained in simple terms.
Cost of goods sold is an accounting term used to refer to a set of costs related to the manufacturing and sale of your product. In other words, it’s the cost of selling your products on Amazon.
Accounting for COGS is necessary for determining true profitability and improving inventory management procedures. It consists of direct and indirect costs.
Direct costs refer to the expenses incurred when manufacturing or purchasing products and may include:
Then there are indirect costs.
Indirect costs are the expenses incurred when selling your product. These include:
Higher cost of goods sold results in a lesser amount of tax imposed on your business activities. However, it also means that there’s less profit to be made. As an Amazon seller, a higher-than-average COGS suggests:
There are numerous other possibilities behind high COGS, and these two are some of the more common ones found among Amazon sellers.
Note: The costs involved in the manufacturing/procurement of inventory not sold during that period will not be included in your COGS.
The formula for the cost of goods sold is:
COGS = Starting Inventory + Additional Inventory – Ending Inventory
Quick Demonstration: You bought $7,000 worth of inventory at the start of the year and an additional $7,000 a few months later. At the end of the year, you had $4,000 worth of inventory left. Your COGS would be:
COGS = $7,000 + $7,000 - $4,000 = $10,000
In practice, there are two ways of accounting for COGS:
When determining the cost of goods sold on Amazon, opt for the accrual accounting method as it more accurately reflects your financial statements. Let’s understand both methods by way of example. Let’s assume you purchased 20,000 units worth of inventory and sold it on Amazon at $5 per product. According to cash basis accounting, here’s your gross profit for the first three months:
Notice anything unusual? For January (which is when you purchased the inventory), you’re recording a loss of $30,000 followed by immense profits of $40,000 and $30,000 for the next two months.
In cash basis accounting, COGS is registered the moment inventory is purchased and comes under your possession. It gives a skewed picture of your financial activities and makes it difficult to gauge how well your business is performing each month.
Using the accrual method, your hypothetical expenses would look something like this:
Instead of counting total inventory as an expense in January, we take them into account the moment an item is sold. Now, you have a better idea of how much profit is being made each month. Even if sales didn’t start rolling in from the first month, you would only expense your products (i.e. take into account COGS) at the time of sale even if that happened to be March or November.
Note: For those that own inventory, the IRS mandates the use of the accrual method of accounting.
Amazon seller fees and cost of goods sold are two different expenses. For example, if it took $20 to manufacture or procure a product (including the packaging and other related costs), $3 to get it shipped to a fulfillment center, and $4 in Amazon seller fees, your COGS will be $23 (manufacturing cost + shipping/freight costs).
The value of COGS for any eCommerce business depends on the inventory costing method. There are three ways you can calculate the value of your inventory: FIFO, LIFO, and Average Cost Method.
To understand how all three methods work, here’s another hypothetical scenario involving you purchasing inventory for the first three months of 2021.
Let’s say you managed to sell 300 units out of the total 600 purchased. The value of our inventory and COGS will differ based on the calculation method.
Short for First In, First Out, FIFO is the most commonly used method of inventory valuation used by companies worldwide. In FIFO, the earliest products purchased (or manufactured) by sellers are sold first.
According to the table above, COGS will be:
200 units x $5 + 100 units x $10 = $2,000
or COGS = $0 + $6,000 - $4,000 = $2,000
Where the first 200 units of January were sold at $5 first plus the remaining 100 units (of February) sold at $10 meaning that our COGS was $2,000. Keep in mind that for FIFO, LIFO, and Average Cost method, we’re calculating COGS for the 300 units we managed to sell. Once that is done, we’ll get to know the value of our remaining inventory.
After determining COGS, determining the value of the ending inventory (based on unsold units) is easy:
100 units x $10 + 200 units x $15 = $4,000
Note: The value of your remaining inventory is based on the 100 remaining units of February plus the 200 from March.
As prices tend to increase with time, your remaining inventory more accurately reflects the actual value of your goods.
As the name suggests, Last In, First Out (or LIFO for short) is the opposite of FIFO. In this method, the newest items are sold first meaning that your inventory valuation will be based on your earliest purchases.
Going by LIFO, the cost of goods sold is:
200 units x $15 + 100 units x $10 = $4,000
or COGS = $0 + $6,000 - $2,000 = $4,000
Where the most recent purchases in March were sold first i.e. 200 units at $15 followed by the remaining 100 units (purchased in February) sold at $10 giving us a final COGS value of $4,000.
As for the value of the remaining inventory:
100 units x $10 + 200 units x $5 = $2,000
Why opt for LIFO? Because it increases COGS resulting in lower taxes. Unlike FIFO, net income tends to decrease with time.
Sellers using this method calculate the average cost of all products over a period of time and use that value to determine COGS as well as the value of remaining inventory. It’s the easiest calculation method but also happens to be the most inaccurate.
The COGS using average cost method is:
300 units x $10 = $3,000
The average cost of all of our inventory comes out to be $10 ($5 for January + $10 for February + $15 for March ÷ 3).
And the value of the remaining inventory:
300 units x $10 = $3,000
The average cost method smooths out variations in COGS caused by extreme fluctuations in price. The downside is that the IRS does not accept the average cost methods so you’ll have to choose either FIFO or LIFO.
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