What is COGS, why is it important for Ecommerce companies, and how it can be reduced?

Ecommerce companies often face a paradox - achieving rapid growth while ensuring profitability - and navigate a delicate balance between them.

However, as is the case with most companies due to the recent macroeconomic headwinds, Ecommerce companies are also increasingly focusing on profitable & sustainable growth.

Therefore, understanding profitability & its key drivers becomes imperative for Ecommerce businesses. This is the first blog in our series of blogs where we intend to cover various aspects of profitability for Ecommerce companies - profitability metrics & how to measure them, their importance, and how Ecommerce companies can optimize profitability.

Let’s kickstart this series by understanding COGS for Ecommerce companies.

One of the first steps towards determining a company’s profitability is to calculate its Cost of Goods Sold (COGS). COGS is a crucial financial metric for businesses across a cross-section of industries, and plays a significant role in the success of Ecommerce companies. Understanding and effectively managing COGS is essential for optimizing profitability, making informed business decisions, and ensuring long-term sustainability in the highly competitive online retail. In this blog, we will explore what COGS is, why it matters for Ecommerce companies, how to calculate it, and strategies to control and reduce it.

What is COGS?

Before delving into the relevance of COGS for Ecommerce companies, it's essential to understand what COGS is and what it represents.

COGS, also often referred to as Cost of Sales, is the direct cost associated with the production or acquisition of the goods that a company sells during a period. Essentially, it helps companies determine how much it costs a company to produce or acquire its products.

These costs include expenses directly related to producing, storing, and shipping the products sold by an Ecommerce company. Some typical components of COGS include:

Cost of raw materials or acquiring a product

Direct labor costs related to production or assembly

Manufacturing overheads

Freight costs, duties & tariffs to bring the product to your warehouse

Product packaging expenses

It is important to note that COGS only applies to those costs that are directly related to producing goods that are intended to be sold.

COGS is a variable cost, meaning it fluctuates in direct proportion to the number of products sold. Unlike fixed costs such as rent, salaries etc which remain relatively constant regardless of sales volume, COGS increases when sales rise and decreases when sales decline.

All indirect costs that are incurred by a company are not included in COGS. For clairty, let’s cover some examples of these costs below:

Marketing & advertising expenses

Costs associated with shipping/delivery of products to customers

Salaries

Rent

Research & Development cost

Admin expenses

Significance of COGS for Ecommerce companies

As we shared in the beginning of this blog, COGS is a key metric for Ecommerce companies. It servces as a key indicator of financial health and operational efficiency. COGS is not just a theoretical concept limited to the realm of finance & accounting, but holds practical importance for Ecommerce businesses with its varied applications by CXOs. It goes beyond mere accounting and financial statements and serves as a dynamic tool that empowers Ecommerce businesses to fine-tune their operational strategies, optimize pricing models, improve profitability and stay resilient in the face of ever-changing market conditions.

COGS, essentially, acts as the compass that guides Ecommerce businesses to make important real-world decisions, influencing everything from inventory management to strategic planning, and finally determining the competitiveness and financial sustainability of Ecommerce enterprises in the dynamic digital landscape.

Let’s explore the importance of COGS from some of these lenses:

Impact on profitability

COGS directly impacts the Gross Margin (%) of companies, a fundamental indicator of a company's profitability. Gross Margin = (Revenue - COGS)/Revenue*100. Ecommerce businesses need to maintain a healthy Gross Margin to cover their operating expenses and in turn generate profit, making it crucial for Eommerce businesses to optimize their COGS.

Strategic pricing decisions

Understanding their COGS enables Ecommerce companies can make strategic, data-driven decisions around their pricing & establish appropriate pricing strategies. Companies need to balance competitive pricing with sustainable profitability levels, and that’s where COGS plays an important role. For example, if COGS is high, pricing can be adjusted to maintain competitive prices while ensuring profitability. Conversely, if COGS is low, businesses might have room to offer discounts or promotions to gain a competitive edge.

Inventory management

Efficient COGS management is closely tied to inventory control. Ecommerce companies must avoid overstocking products, as excess inventory ties up capital and increase carrying costs. On the other hand, understocking can result in lost sales and dissatisfied customers. COGS helps in evaluating how well a company is managing its inventory levels.

Financial planning

Accurate COGS data is crucial for financial forecasting and budgeting. It helps Ecommerce companies estimate their cash flow, plan for future growth, and secure financing if necessary. Historical COGS data & its trends acts as a good starting point for companies to predict their future costs & profitability.

Taxation and Compliance

Since COGS represents the cost of producing or acquiring products sold by a company, it serves to reduce the taxable income of companies by that amount. This makes it extremely important for companies to track their costs & measure COGS accurately, to ensure accurate tax reporting and compliance with regulatory requirements.

Product-level performance

COGS is an important metric for evaluating the performance of individual products, product categories, and suppliers. It helps identify which products contribute the most to the bottom line and which ones may need reevaluation or discontinuation.

Continuous improvement

Like most Financial metrics, it is important to keep a cadence of measuring COGS. Regular monitoring & tracking of COGS fosters continuous improvement in companies. Adopting continuous cost optimization & process improvement, Ecommerce companies can leverage to adapt to changing market conditions and improve their bottom line.

How to Calculate COGS

Companies can calculate COGS for a reporting period, using the following formula:

COGS = Beginning (Opening) Inventory + Purchases - Closing Inventory

Beginning Inventory: The value of inventory at the beginning of the period.

Purchases: The cost of acquiring additional inventory during the period, including raw material cost, product cost, direct labour, product packaging etc.

Closing Inventory: The value of inventory at the end of the period.

In order to calculate the Gross Profit, you can simply subtract the COGS from Revenue:

Gross Profit = Revenue - COGS

Let’s understand this better with a numerical example: let's consider an Ecommerce company, ABC Inc., is in the business of selling beauty products with the following inventory data & Revenue:

Opening Inventory: $25,000

Purchases: $50,000

Closing Inventory: $20,000

Revenue = $150,000

Using the COGS formula:

COGS = $25,000 + $50,000 − $20,000

COGS = $55,000

Therefore, Gross Profit = $150,000 - $55,000

Gross Profit = $95,000

So, in this example, the Cost of Goods Sold (COGS) for ABC Inc. is $55,000 and Gross Profit is $95,000. Meaning that the cost of beauty products sold by ABC Inc. during the period was $55,000.

It's important to note that the values used in this example are simplified, and in real-world scenarios, there might be additional factors and details to consider, such as any additional direct costs associated with the production of goods.

How Ecommerce companies can control and reduce COGS

Ecommerce companies can employ several strategies to control and reduce COGS, ultimately improving their bottom line:

Supplier Negotiations: The first (and probably the most important!) step towards optimizing your COGS is focus on continuous optimization of product/raw material costs. It obviously makes it easier as the company scales: ensuring that with increasing purchases from your vendors you can negotiate better rates. Leave a room for further negotiation & don’t lock your prices for long period, if you are confident that the sales will grow significantly in the upcoming periods. This allows companies to not just lower product costs, but also better payment terms, reducing overall working capital.

Inventory Optimization: Ecommerce companies, should wherever possible, Implement inventory management & optimization systems that help them better predict demand, supply chain management solutions. This helps them prevent overstocking and understocking, resulting in lower working capital costs & lost sales. Supply chain management solutions also help companies enhance efficiency and accuracy in order fulfillment and reduce operational costs.

Packaging Optimization: Packaging often tends to become a significant cost for Ecommerce companies especially D2C brands, that need to stand out against the competition with a unique & appealing product design & packagin approach. While this is crucial, companies can leverage novel designs & packaging materials to packaging and production costs. Efficient packaging not only reduces material expenses but can also lead to lower shipping costs.

Quality Control: Focus on quality control & ensuring freshness. These are significant factors that can contribute to higher return rates for Ecommerce companies, with freshness becoming crucial in case of perishable products or those with expiration dates. Reducing the number of defective or returned products can minimize the cost of product replacements, returns processing, and customer service.

Technology and Automation: Implement technology and automation solutions to reduce or completely eliminate dependence on manual processes. These processes aren’t just prone to errors and are tedious, but could also act as significant bottlenecks towards getting correct & relevant business/financial data in time for decision making. Ensuring that CXOs are always reacting to historical data i.e. lagging indicators. New age technology platforms like FinanzOS, help Ecommerce businesses automate/optimize key business & financial processes, reduce errors, improve efficiency, and make data availability for decision-making super easy. Ensuring that companies can now take decisions based on key leading indicators.

Data Analytics: Ecommerce companies can adopt new-age analytics platforms like FinanzOS, that help them aggregate key data from disparate data sources incl. Marketplaces, own online stores (Shopify, WIX, WooCommerce etc), payment solutions, among others for a deep-dive into the pricing levers, sales trends and inventory data to identify demand & sales patterns, and work on continuous identification of opportunities for cost reduction.

Process Efficiency: Streamlining production, order fulfilment, and shipping processes can help reduce labour and overhead costs.

Supplier Diversification: Working with multiple suppliers or manufacturers can reduce the risk of supply chain disruptions and provide negotiating leverage.

How FinanzOS can help

FinanzOS is an AI-powered Automation, Analytics & Intelligence platform that is purpose-built for Ecommerce companies & D2C brands to to take control of their fragmented, unorganized & siloed data. It integrates with

Automate & streamline key processes: This includes automating tracking of inventory costs for a given period; removing manual, lengthy and error-prone data gathering processes that impact tracking & monitoring key metrics such as COGS,

Real-time Analytics & Intelliegence: Deep dive into your key data incl. sales, orders, inventory, advertising costs, among others to take better, data-driven decisions,

Identify inventory losses: Identify missing, damaged, expired, or partially returned inventory from order returns, and the key reasons behind each of them. Helping Ecommerce companies optimize their COGS, and improve customer satisfaction & loyalty by improving product quality & reducing customer returns.

FinanzOS effortlessly integrates with 100+ platforms incl. marketplaces, ad platforms, marketing platforms, accounting software, payment gateways, OMS, WMS (and a lot more) where the siloed data of Ecommerce companies resides. By doing so, it helps them identify key cost & revenue leakages in their operations with its AI-powered Reconciliation engine, automate their key manual processes & workflows incl. Accounting & Bookkeeping, saving up to 70% on them, and improve their business outcomes by enabling them to make faster, better data-driven decisions.

To know more about how FinanzOS is helping Ecommerce companies with the above, please reach out to us at [email protected] or [email protected] or click here.