Calculating Cost of Goods Sold
Various implicit factors – including competitor pricing, customer expectations, perceived value, and product demand – are all important considerations when it comes to pricing. But one explicit factor, your cost of goods sold – or COGS – is critical when it comes to setting your prices.
Your cost of goods – or how much you paid to produce or acquire the products you’re selling – represents a floor, and setting prices below that floor can have negative implications on your profitability. Sell items for lower than your cost of goods, and you’re not making money.
Here, we’ll cover what cost of goods is, how to calculate cost of goods, why cost of goods is important and some examples and use cases for winning product pricing strategies.
What is cost of goods sold?
When an ecommerce store purchases inventory from a third party, their cost of goods sold is equal to the expense associated with obtaining that inventory. When a store manufactures their own inventory, on the other hand, their cost of goods refers to the expenses directly associated with producing the products, like the cost of raw materials and labor.
Here’s a quick list of what’s commonly included – and not included – in cost of goods for a clothing manufacturer and retailer:
Included: Fabric, labels. buttons, thread, machinery and equipment, labor for design and manufacturing
Not included: Marketing costs, overhead costs, indirect labor costs (i.e., for employees not directly involved with the production of your clothes)
How to calculate cost of goods sold
If you’re calculating cost of goods sold manually, you’ll use this formula:
Cost of Goods Sold = Starting Inventory + Purchases Made During Period – Ending Inventory
Your starting inventory is the total value (cost) of the inventory remaining from the previous period. Then, you’ll add in the cost of products you purchased or manufactured during the reporting period you’re looking at. Lastly, you’ll subtract the value of the inventory you have leftover at the end of that same period.
To get to those values, remember to take into account what goes into your product costs: only the direct expenses associated with obtaining your inventory.
Here’s an example:
Consider the same clothing retailer as before – they’re calculating their cost of goods sold for the previous quarter. Their starting inventory at the beginning of the quarter was $20,000. Over the course of the quarter, they manufactured $15,000 in additional inventory. They ended the period with $16,500 in inventory.
Cost of Goods Sold = $20,000 + $15,000 – $16,500
Cost of Goods Sold = $18,500
The most basic use for cost of goods sold? Using it to calculate your gross profit, since gross profit is calculated by subtracting cost of goods sold from revenue.
In the example above, if the clothing retailer made $45,000 in revenue in the same quarter:
Gross Profit = Revenue – Cost of Goods Sold
Gross Profit = $45,000 – $18,500
Gross Profit = $26,500
In this example, you can easily see how cost of goods sold affects a business’s profitability. If the retailer had had higher inventory expenses (in the form of additional inventory purchased or less inventory sold) that quarter, it would have cut into their gross profit significantly.
Why it’s important to calculate cost of goods sold
Accurate COGS data helps businesses price their products strategically and understand their top-line profitability – you need to know how much you spend on the products you sell to understand what to price them at, as well as how much money you’re actually bringing in. Understanding cost of goods sold also helps stores strategize how to best market products based on profit margin (another way to think about profitability on an individual product level – margin is the percentage of profit made from the sale of each product).
For example, a t-shirt with a 15% margin could be a good candidate for a scalable email marketing campaign, while a higher-end bag or dress with a 70% margin could be a good candidate for more expensive forms of marketing like paid search or social media ads.
In addition to marketing strategy considerations, stores can use cost of goods sold to price products more efficiently, so that margin is available to pay for operating expenses related to maintaining and scaling their business. Examples of these operating expenses include web hosting fees, development expenses, or the cost of maintaining an office space.
Product Pricing Strategies
1. Cost-plus pricing
2. Target Return Pricing
3. Competitive Pricing
4. Value-Based Pricing
How Glew Helps Calculate Cost of Goods
Our tool allows users to connect to COGS data in their ecommerce platform or import COGS data in bulk using a CSV template, and provides the ability to modify COGS data for individual products for the most accurate starting point.
Integrated cost of goods sold data in Glew helps ecommerce stores understand their true profitability, optimize marketing strategy and advertising spend relative to product profitability and move away from a more generalized approach to product marketing.