Tracking inventory accurately and calculating your cost of goods sold (COGS) is one of the most important metrics for your retail business. Often, for ecommerce brands, it can also be one of the most complex and daunting tasks.
Not a great combo. Right?
Let’s break it down. In this post, we’ll help you understand why tracking your inventory matters, and how to make it smoother.
And then you can get back to business. Let’s go.
Why does it matter for my business?
Imagine a customer visits your Shopify store. She spends time searching for the perfect gift for Mom’s birthday. After reading your carefully-worded product descriptions, she selects an item she knows Mom will love and happily forks over the funds. An hour later, she receives an alert from you letting her know that item is out of stock.
Now you are disappointed, the customer is disappointed, and most importantly, Mom is disappointed.
As an ecommerce seller, you need to know how much inventory you have, when to reorder, and how much to reorder. Because out-of-stock items can hurt your bottom line, customer retention, and your overall brand. This process is often known as inventory management.
What you may not know is that inventory management alone is not enough.
Obviously, accurate inventory management is crucial for managing the commercial side of your business so you can track how many units you need to reorder and when but you also need to understand accounting for inventory costs to help you correctly assign a cost per unit for your inventory.
A correct cost per unit helps you calculate your ending inventory balance, COGS and profit margin. Without these numbers correctly accounted for, your whole pricing model and projections may be skewed and your balance sheet and P&L would be as helpful to you as a treasure map drawn by your dog.
The good news is that if you do it correctly, you can usually accomplish both inventory management and accounting for inventory in the same process. The first step is to make sure you understand all of the various components that should be taken into account when valuing your inventory.
Let's start with a recap of some inventory basics.
What is inventory?
The textbook definition of inventory is the products and materials your business owns for the purpose of resale or production. For example, for your homemade chocolate chip cookie business, this may include chocolate chips, sugar, packaging for the cookies and the ready-to-ship baked and packaged cookies.
It sounds simple enough, but this definition could (and often does) mean different things to different people.
Why is it so complicated?
- Most people don’t understand which costs to include in calculating inventory or COGS. Should you include only finished products or also packaging supplies? Inventory on hand or also inventory in transit? What about inventory ordered but not yet paid for? The different variables are enough to give anyone inventory anxiety.
- It’s a constantly changing metric. It can be (and hopefully is) a metric for your business that is constantly changing every time you sell, manufacture, or order products.This makes it complicated to maintain updated reports.
What costs should be included in inventory?
To maintain accurate financials, you’ll want to think about how to track your inventory costs.
As a general rule, you should include products and supplies that your business owns that are either:
- Physically on hand (e.g., in a warehouse)
- Purchased but not yet received
You can use one inventory account or separate inventory accounts to track your inventory, depending on the chart of accounts being used in your financials. When tracking inventory costs, you should include:
- Direct purchases of ready-for-sale items (also known as finished goods)
- Raw materials
- Packaging and labeling supplies (since these items are usually purchased in bulk but used at the rate of actual sales)
- Shipping/ freight costs to ship the stock to your warehouse (such as global shipping)
- Other indirect vendor costs, such as sales tax and vendor fees
- Manufacturing / assembly costs (e.g., direct labor, contract manufacturers, manufacturing overhead) if you manufacture your own products
For purposes of simplicity, let's refer to the above as “Inventory Costs”.
When it comes to unpaid bills for inventory, whether or not you include these bills in your costs depends on whether you keep your books in cash or accrual.
For accrual basis books, you should include all costs whether they were paid or are still owed to the supplier.
For example, if you ordered 500 units from a vendor and are required to pay 50% today and 50% when you receive the units, you should include 100% of the cost in inventory.
If you keep your books on a cash basis, you should only include the costs actually paid.
How should inventory be calculated?
Now that we understand the Inventory Costs that you should take into account in valuing your inventory, let’s do a quick run-through of the key inventory terms for calculating your ending inventory balance.
- Beginning inventory - balance of your Inventory Costs relating to unsold inventory at the start of the month (this is the same amount as your Inventory Costs at the end of the previous month).
- Purchases - Inventory Costs relating to new inventory purchased during the month that you already legally own. This generally also includes inventory that is in transit to you.
- Manufacturing costs - Inventory Costs related to manufacturing of the products, e.g., contract manufacturers, direct labor or other manufacturing costs.
- Cost of goods sold (COGS)- estimated Inventory Costs for units sold during the month. This is often calculated as a cost per unit amount and can be calculated based on different methods as described below. The cost per unit amount should not include shipping costs to customers, customs warehouse fees, payments fees or marketing costs.
- Ending inventory - Inventory Costs relating to the unsold inventory at the end of the month.
- Dead inventory- The estimated cost of loss or breakage of inventory, e.g., broken or spoiled inventory, loss of purchases in shipment, etc.
- Product giveaways - Inventory Costs for stock you gave away for marketing (e.g., to influencers).
Calculating your COGS
COGs are calculated based on a cost per unit determined using one of the following accounting methods:
- FIFO (first-in, first-out) method assumes that the first unit purchased is the first sold. Let's see this in action. You purchase 200 phone cases for $1 each on Sunday and another 200 phone cases for $1.50 on Wednesday. On Thursday, you sell 100 phone cases. Under FIFO, your Thursday COGS would be based on a cost per unit of $1 each resulting in COGS of $100.
- LIFO (last-in, first-out) method assumes the last unit purchased is the first one sold. Let's take the same example as above. The 100 phone cases you sell on Thursday would have a cost per unit of $1.50 resulting in COGS of $150.
- Average cost method takes the weighted average cost of all units available for sale to determine the cost per unit. Using the same example as above, your cost per unit for the units sold on Thursday would be $1.25 each (200 cases for $1 + 200 cases for $1.50/400 cases).
As a general rule, the average cost method and FIFO method tend to be more commonly used by ecommerce businesses like you to calculate your COGS and result in a more accurate measurement of your COGS and unsold inventory.
Calculating your ending inventory
As a best practice, you should update your inventory values on a monthly basis.
Here’s how to calculate your inventory:
At first glance, this formula can seem overwhelming so let's break it down step by step:
- Let’s start at the very beginning - your beginning inventory, that is. Then we will add/ subtract any inventory changes that took place during the month.
- Add Inventory Costs for purchases made during the month and manufacturing costs for services received during the month.
- Subtract COGS (i.e., Inventory Costs related to products sold during the month on your website or through wholesale channels).
- Subtract product giveaways and dead inventory. This is a part of the inventory equation that is often missed. For ecommerce businesses, this can really add up and should be taken into account when tracking your inventory.
Ta da….Now you have your ending inventory. Easy as pie, right?
We know it sounds complex but once you have the process in place it works like a well-oiled machine....or at least a well-oiled, high maintenance machine.
How Finaloop can help
As ecommerce accounting specialists, we understand the importance of making sure your inventory and COGS are properly recorded in your financials. We also understand the complexities faced by ecommerce brands like you in making sure these metrics get tracked properly.
To simplify this process, Finaloop provides our users with a monthly inventory tracker and a COGS calculator that ties with the purchases in your bank feed and your cost of goods sold pulled from Shopify. These tools were created to help you save time while ensuring you have accurate data and insights into your expenses each month.
We are a technology company providing automated end-to-end accounting service to ecommerce businesses. Our system connects to your apps, syncs all your data and reconciles your books in real-time, replacing your bookkeeper. We offer reconciled books available 24/7, tax-saving insights, and a single place for all your financial data.
*The information provided on this website does not, and is not intended to, constitute legal advice. All information, content, and materials available on this site are for general informational purposes only. Readers are advised to consult with their attorney or accountant with any questions or concerns.*