What is Cost of Goods Sold?
The Cost of Goods Sold, or COGS for short, is as it sounds; it is the cost of your inventory after sold to a customer. This calculation includes all of the costs associated with the sale of the product including freight. However, it does not include any expenses associated with selling the merchandise like payroll or rent. Knowing your Cost of Goods Sold can be a great tool in running your retail business, especially when you can compare your COGS to other retail stores in your same industry.
It is calculated as:
Beginning Inventory + Cost of Goods Purchased - Ending Inventory = COGS
Let's say you own a shoe store. At the end of the month, you want to see what your Cost of Goods Sold was for that period. If you had $100,000 worth of shoes at the beginning of the month and you bought $10,000 worth of shoes during the month and you had $50,000 worth of shoes at the end of the month, then your COGS would be $60,000. ($100,000 + $10,000 - $50,000 = $60,000)
If you buy a shoe for $50 from a vendor and it costs you $5 to have it shipped to you (freight,) on your books (commonly referred to as your income statement or P&L) you have $55 for COGS. If the next time you order the shoe the vendor has increased the price $5, then the new shoe will be $55 plus $5 in shipping for a total of $60. You do not change the price of the shoe you already have in stock. COGS does not change on an item once it enters the store.
However, depending on the inventory accounting method your accountant is using, he or she may be able to chart which COGS to use when the item is sold. There are two main types of inventory calculation methods - FIFO and LIFO.
FIFO or “First-In, First-Out” assumes that the oldest units of inventory are always sold first.
LIFO or “Last-In, First-Out” assumes the opposite - that the last one to come in is the first one to go out. For more info on these methods, read this article.
Properly managing inventory is the key to successful retailing. Too much inventory can leave you with cash flow problems and too little inventory can leave you with sales or revenue problems. It is an incredible balancing act that is equal parts of art and science.
Too Much Inventory = Cash Flow Problems
I have sat across the table from many retailers who are confused and frustrated with their business. They show me a P&L that says they made money last month. Yet, their bank account shows they are losing money. The main reason for this is cash flow. When you buy an item for your inventory, it will have a period of time (known as dating) that you have to pay the vendor for it. The best retailers sell (turn) their inventory before the payable is due. However, this is very hard to do.
The problem with the P&L is that it shows you what happened during that month. However, it does not show you what happened the month before when you bought the shoes that now need to be paid in this month. Cash flow problems happen when retailers fail to account for their payables in their sales planning. Be careful not to get seduced by a "great" offer from a vendor only to have to pay for it later.
Too Little Inventory = Sales Problems
The main reason a retailer will lose a customer is being out of stock on an item. Many retailers are so afraid of this that they overbuy and have lots of "extras" just in case. But that gets them into the cash flow problems we just discussed. So how do you mange this dilemma?
One of the best tools you can use to manage inventory is an open-to-buy system. This process helps you buy only the merchandise you need. It uses COGS and inventory turns to determine how much more inventory you need compared to what your sales trends have been.
Another great idea is to buy "at once" merchandise for your store. This is merchandise the vendor stocks in its warehouse for immediate shipment. So if you can order a shoe and get in to your store within 5 days, there is no need to carry 10 of them. You just need enough to get you through the five days.
Another key metric to monitor in retail is gross margin. Since you now know the COGS, you can figure the gross margin.
Total Sales - COGS = Margin
For example, if you sold $100,000 worth of shoes during the same month you calculated above for COGS you would subtract your COGS of $60,000 to determine your gross margin of $40,000. Gross margin can be expressed as a dollar amount or a %, but the % is the most common way to review and analyze gross margin. (Here is a great article to help you with gross margin.)