Retailers need to track the cost of goods sold (COGS) to ensure they are profitable and reporting expenses to the IRS correctly. Considering that 60% of small business owners feel they don’t have enough knowledge about accounting and finance, it’s a good idea to understand how COGS can impact your accounting and sales. This guide will walk you through what’s included in COGS, how to calculate it, and different ways to help prepare for tax season.
What is COGS?
Cost of goods sold (COGS) is the direct cost of producing products sold by your business. Also referred to as “cost of sales,” or "COGS report," COGS includes the cost of materials and labor directly related to the production and manufacturing of retail products. COGS excludes indirect costs, such as distribution and marketing.
Benefits of Understanding COGS
Using COGS for your retail store is crucial for a number of reasons:
- Understand cash flow
- Manage tax liability
- Ensure profitability
- Accurately price products and keep healthy margins
What's included in Cost-of-Goods (COGS)?
Direct Costs vs. Indirect Costs
Direct costs are expenses that are directly tied to the production of goods or services. Indirect costs are expenses that cannot be directly attributed to the production of goods or services. COGS includes only direct costs.
Examples of Direct Costs
- Raw materials
- Labor costs directly related to production
- Packaging and shipping costs
- Manufacturing overhead
How to Calculate COGS
The formula for calculating Cost of Goods Sold for retail businesses is:
COGS = Beginning Inventory + Purchases – Ending Inventory
Beginning Inventory: The value of inventory at the beginning of the accounting period. This can be found on your balance sheet for the previous period.
Purchases: The total cost of all inventory purchases during the accounting period.
Ending Inventory: The value of inventory at the end of the accounting period. This can be found on your balance sheet for the current period.
It is essential to note that COGS only includes direct costs related to the production or acquisition of goods and excludes indirect expenses such as distribution costs, sales force costs, and administrative expenses.
Let's consider an example to illustrate the calculation of COGS for a retail store:
Suppose a retailer has the following information for the year 2019:
Beginning Inventory: $250,000 (from the balance sheet for the year ended 2018)
Ending Inventory: $275,000 (from the balance sheet for the year 2019)
Purchases made during 2019: $75,000
Using the COGS formula, we can calculate the Cost of Goods Sold for this retailer as follows:
COGS = $250,000 (Beginning Inventory) + $75,000 (Purchases) – $275,000 (Ending Inventory) COGS = $50,000
In this example, the Cost of Goods Sold for the retail store in 2019 is $50,000.
This figure represents the total cost of inventory that the retailer sold during the year, including costs such as product cost (wholesale price from the supplier), freight, handling, labeling, barcoding, and customs duties.
It is important to note that some costs, such as warehousing, packaging and shipping expenses for products from the retailer's warehouse to the end user, and merchant fees (e.g., PayPal or credit card processing fees), are not included in COGS. These costs are considered operating expenses and should be accounted for separately when analyzing the financial performance of a retail business.
Inaccurate COGS calculations can lead to negative consequences:
1. Financial Loss: Errors in COGS calculation can result in financial losses for a company. For example, if a company overestimates its COGS, it will report lower net income and understate its ending inventory on the balance sheet.
2. Misinformed Business Decisions: Inaccurate COGS and inventory values can lead to poor business decisions, such as overstocking or understocking inventory items, resulting in increased expenses and reduced profitability.
3. Inaccurate Financial Statements: Errors in COGS calculation can cause inaccuracies in financial statements, which may affect a company's ability to secure investments or financing.
Best Practices for Accurate COGS Calculation
To ensure accurate COGS calculation, retail businesses should consider the following best practices:
1. Choose an Appropriate Inventory Costing Method: There are several inventory costing methods, including First-In, First-Out (FIFO), Last-In, First-Out (LIFO), and Average Cost Method. Selecting the most suitable method for your business can help improve the accuracy of COGS calculation.
2. Maintain Accurate Inventory Records: Regularly updating and reconciling inventory records can help prevent discrepancies and errors in COGS calculation.
3. Implement Efficient Inventory Management Systems: Utilizing inventory management software or tools can help streamline the process of tracking inventory levels, purchases, and sales, leading to more accurate COGS calculations.
Using COGS for Pricing Strategy
COGS as a Baseline for Pricing
Knowing your COGS helps you set a baseline for pricing your products. It’s important to price your products above your COGS so that you make a profit. However, pricing your products too high could result in decreased sales and lower profits. By using COGS as a baseline for pricing, you can ensure that your products are priced competitively while still generating a healthy profit margin.
COGS used to Adjust Pricing
COGS can also be used to adjust pricing during sales and discounts. For example, if you’re offering a 20% discount on a product, you can use your COGS to determine the lowest price you can sell the product for while still making a profit. This ensures that you’re not losing money on the sale and helps you maintain a healthy profit margin.
Adding a Profit Margin
In addition to covering your COGS, you’ll want to add a profit margin to ensure that your business is sustainable in the long run. This margin should be based on your industry standards and your own business goals.
Covering Indirect Costs
When setting your prices, it’s important to ensure that you’re also covering your indirect costs, such as rent, utilities, and marketing expenses.
Importance of Tracking COGS
Ensuring Profitability
By tracking your COGS, you can ensure that your business is profitable. If your COGS are too high, you may need to adjust your pricing or find ways to reduce your direct costs.
Accurate Reporting to the IRS
COGS is an important expense category that must be reported accurately to the IRS. By tracking your COGS, you can ensure that you’re reporting your expenses correctly and avoiding any potential penalties.
Preparing for Tax Season
COGS is also important for tax purposes. By accurately tracking your COGS, you can reduce your taxable income and lower your tax liability. This is because COGS is subtracted from your revenue to determine your gross profit, which is then used to calculate your taxable income.
Tools to Track COGS
Clover Reporting
Clover is a point-of-sale (POS) system designed for small businesses. In addition to its POS features, Clover offers reporting tools that can help you track your COGS and other important financial data.
SKU IQ
SKU IQ is an inventory management software that syncs with your POS system and e-commerce platform. It helps you keep track of your inventory levels, sales, and COGS in real-time.
Other Inventory Management Apps
There are many inventory management apps and software solutions available to help you track your COGS. Some popular options include Vend, QuickBooks Commerce, and Stitch Labs. Choose the one that best fits your needs and budget.
Importance of COGS for Retailers
COGS in retail is essential for maintaining profitability, accurately pricing products, and preparing for tax season. By tracking your direct costs and calculating your COGS regularly, you can ensure that your business remains financially stable and successful.
As a retailer, it's important to invest in the right tools and resources to help you manage your COGS effectively. This will not only make your life easier but also contribute to the long-term success of your business. So, take the time to educate yourself and your team about COGS, and don't hesitate to seek professional advice if needed.
