Cost of Goods Sold Basics for e-Commerce Businesses with Journal Entries

Cost of Goods Sold Overview

If you've ever heard someone talk about "making a dollar out of 15 cents," consider the 15 cents to be COGS. COGS, or Cost of Goods Sold is how much it costs a company to generate revenue. In other words, it's the cost of doing business. These costs include materials purchases, packaging, and the labor costs of making your materials into sellable products.

Cost of Goods Sold Basics for E-Commerce Businesses

COGS is a key metric that tells a lot about how a business is truly performing. Complex processes and lack of in-house accounting knowledge can complicate this. Here are some Cost of Goods Sold basics that business owners need to understand.

How Do I Know What To Include in COGS?

If you're unsure if an expense should be included in COGS, think about what the cost is for. Any expense incurred that is (1) necessary to generate revenue and (2) directly impacts creating a sellable product must be included in Cost of Goods Sold calculations.

For a company that sells candles, the following expenses would be included in COGS:

  • Wax ingredients & wicks (or candle waxed purchased from a supplier)

  • Candle jars

  • Jar labels

  • Machines or equipment used to make candles

  • Cost of employees or contract labor to produce candles

  • Cost of boxes and packaging to ship candles to customers (customer shipping costs are not part of COGS)

COGS is presented on the income statement below revenues; the net of COGS and revenues equals gross margin, a metric often discussed ad nauseum in financial statement analysis. Besides accounting, these discussions often involve operations, procurement, supply chain, and sales teams because of the significant impact of COGS on a company's performance.

Questions about how to maximize revenue or generate more cash center around COGS analysis. For example, a company wanting to improve its margin will look to the procurement team to negotiate more favorable terms with vendors to realize cash savings. The controller may inquire with supply chain about the timing of shipping orders to customers, which impacts COGS. The accounting or AP manager may ask the staffing agency to send invoices sooner to avoid accruals which, with estimates and reversals, could make the numbers more complex.

COGS Journal Entries

COGS is recorded in the same period as the revenue that it helped generate. If the candle company sells 50 candles in August, the cost of making those 50 candles must also be recorded in August. This ensure that your financial statements are accurate and compliance with U.S. accounting standards. Suppose the candle company sold 40 candles in September for $2,000. The total cost of making the candles was $800. The company will record the following journal entries in June:

DR Cash 2,000

CR Revenue 2,000

To record sales revenue from candles sold

DR Cost of Goods Sold 800

CR Inventory 800

To record COGS for making the candles that were sold

The candle company's gross profit is $1,200 ($2,000 in sales minus $800 for candle-making expenses). The company's gross margin percentage is 60% ($1,200 gross profit divided by sales). In reviewing these transactions, your CPA can tell the story of what's happening in the business and call out things like:

  • A 60% gross margin means that it costs 40 cents (1-0.60) for the company to make $1 in revenue.

  • Is a 60% margin good for the industry? Is my business performing similar to or better than competitors?

  • Have you captured all expenses in COGS?

  • What improvements can be done to improve COGS?

  • What favorable payment terms can be negotiated with vendors?

The Messiness of COGS Accounting

This is an oversimplified example of COGS - many revenue-generating activities can get complicated. As a business owner, it's important to have documented processes that outline steps in the production process where expenses are incurred. This ensures you don't miss any expenses in your gross margin calculations.

Contract Labor Complexities

Suppose a company uses an external staffing agency to retain contractors to make the candles in the factory. If you're lucky enough to get accurate agency invoices on a timely basis be proud, but the majority of business owners must accrue, adjust, and update contractor listings to ensure your labor costs are accurate.

Contract labor can get messy with accruals and reversals, invoice discrepancies, and reconciling payments. It can be worse if your accounting staff lacks the knowledge to know how to handle this, which could distort your margin numbers.

What are Operating Expenses?

Gross margin includes all materials and labor directly involved in creating products to sell. All other costs that are not directly related to creating products are indirect expenses. For example, office supplies, marketing, rent, and management salaries are operating expenses that are not included in COGS. These costs are deducted from