Why Inventory Accounting is So Hard (yet SO IMPORTANT) for Ecommerce Brands

Hello, Brittany.

0:47 Brittany Brown

Thanks for having me, Stephen Brown.

0:49 Stephen Brown

Do you want to introduce yourself?

0:52 Brittany Brown

Yeah. So one of the things that he didn't say is that I'm also his wife and his business partner. So we co-own LedgerGurus together. We've been working together in the business for about nine years now. So I founded LedgerGurus on my own with some side hustling from Stephen, and then about two years in he got involved full time. So ever since then we've been both life partners and business partners. So man, we should do a whole podcast on what that's like.

1:20 Stephen Brown

Yeah, that'd be exciting.

We're actually sitting one wall apart, but we don't have the studio set up to where we can be in one room. So for recording purposes we're actually in different rooms. If you're watching the video, that's why you see different backgrounds.

1:35 Stephen Brown

What I want to talk about today, and I wanted Brittany to join me, because one of the things, if you haven't heard of Brittany Brown, Brittany is one of the smartest accountants, financial professionals, in ecommerce. She probably understands more about ecommerce accounting and finance than almost anybody in the industry. I'll bet somebody on that.

But one of the biggest problems we run into is inventory and cost of goods sold accounting. So if you're an owner, don't drop off. We want to talk to you specifically. Accountants already know this problem, but we want to talk about why this is so important and so challenging.

2:17 Why it's so difficult

Stephen Brown

So to start us off, Brittany, tell us, why is inventory and cost of goods sold accounting so difficult for a consumer products business?

2:25 Brittany Brown

Yeah. So it really requires a lot of operational maturity in order to be able to get financial numbers right. And that's probably where it becomes the most challenging.

So in most other areas of the business, like I think about the channel reporting around the revenue side, you're doing your stuff on the channel and all the sales are happening and it's processing through whatever payment processor, and there are minimal steps from activity to financial implications. And it's quite easy, because the road is quite short and the complications within that road are almost non-existent. It's very easy to get clean and accurate financial data. Especially if you know what you're doing, it's just a very direct road there.

3:05 Brittany Brown

And that would be true for almost any other aspect of the business. You go and you buy something at Office Depot and you code it as office supplies, and basically you're done. You made a purchase, you coded it, you're done.

That is not even close to being true with inventory accounting. In inventory accounting, first of all, the operational side of inventory, as you brand owners already know, is really, really challenging. Every single time we have a new sales call with a client, the very first thing they always complain about is inventory. And what they're really talking about is the operational side of it, but they're also recognizing now the downstream financial implications of the operational issues.

3:45 Brittany Brown

So if you think about how complicated it is to just try to keep track and to manage inventory. What needs to be ordered, what's in transit, what you have on hand, which warehouse it's in, what's been sold, what's been returned, where it's sitting. That's a relatively simple scenario before you even start getting into things like what's been bundled, what's been manufactured, what's been assembled. That's not even talking about that level of complexity.

If you think about just how hard of a time brand owners have just keeping their head around the quantities and what's available and where it is, now multiply onto that the significant additional complexity of now assigning value to those inventory items.

4:35 Brittany Brown

And trying to decide how you're going to value it. Are you going to look at just buy costs? Are you going to wrap in the landed costs? What if you get a different shipment and the costs of that shipment are considerably different, but you had a big stack of inventory already sitting there? And what if we threw a bunch of stuff away but we didn't record that it got thrown away? What's happening to the value of all that?

So when you talk about the simplicity of other financial transactions that basically go from activity to reporting, and it's maybe two or three steps, when you talk about inventory there are many steps involved in that, and every single one of those steps has a financial implication. And there are so many fail points for that financial information as it's flowing through.

5:30 Brittany Brown

The reason why inventory accounting is so complicated is because operationally inventory is very complicated, and financially now we're adding a whole nother layer on top of something that is already very complicated.

5:46 How inventory flows to COGS

Stephen Brown

I want to dive into a different concept of inventory accounting that is complicated. And this is going to be hard to do verbally, because most people are listening.

But when we talk about inventory accounting, it's touching two financial statements. It's touching the balance sheet and the profit and loss, if you're doing accrual. And so let's talk about these concepts, Brittany. You're really good at explaining accounting concepts. Let's talk about how inventory flows from the balance sheet to cost of goods sold when you're doing it on an accrual basis, and why people should be doing it on an accrual basis.

6:21 Brittany Brown

Yeah, that's a great point. It's another primary difference of the way that a lot of activity flows through the business differently.

I'll go back to the example I used a second ago, which is if I walk into Office Depot and I buy some office supplies, I'm going to come back and I'm probably going to record that expense as of the time that that transaction hit my credit card or hit my bank account. So that's a pretty clean example of a cash accounting transaction.

6:50 Brittany Brown

So inventory is not only tracked on an accrual basis, but it is a complicated accrual process. And what I mean by that is, if I was to go and buy $100,000 of inventory, and let's say that I only do maybe $10,000 a month of sales, that inventory probably represents maybe six to 10 months worth of inventory.

And if I was to just expense all of that in that first month, so let's say I make this decision in January, the month of January is going to show this huge loss. I'm going to show $100,000 of cost of goods sold expenses, and in that month it's going to look really, really poor, like I performed really poorly financially.

But then the other half of the problem is, in every month that comes after that, now I have no inventory costs associated with any of those months following, because I've already expensed it all in the first month.

7:45 Brittany Brown

So it makes it so if I do this wrong, which is to basically immediately hit the profit and loss with this, then it actually skews every single month that's affected by that inventory. Not even just the first one, every single month. The first month basically gets a sucker punch to the gut, and every month after that gets to frolic through the fields unburdened by any of the costs that are associated with it.

So what has to happen instead is we have to take that inventory and we have to settle it onto the balance sheet, to wait for it to be sold. Even the phrase cost of goods sold is designed to capture the idea that we're going to cost the product that was actually sold during that period of time.

8:30 Brittany Brown

And so it sits on the balance sheet as an asset, an inventory asset. And then each month that goes by we incrementally remove it from the balance sheet, and in that month that it's actually sold we recognize the cost of goods sold associated with it, month by month, incrementally, as it's actually sold.

So if I bought $100,000 in January and it took me six to 10 months to actually sell that, each month you would see some portion of that $100,000 until it had been entirely used up as it was entirely sold. So that's the way that it flows, and that's the reason why it's managed the way that it is.

Otherwise it creates extreme volatility on the financials, and a complete inability to see whether the business is even profitable or not, or how it's performing month in and month out. Because cost of goods sold is the most significant expense product businesses experience. And if you're not doing this process correctly, you have complete lack of visibility into how your business is doing.

9:27 Stephen Brown

Yeah. And I think that's the key point you articulated, is I don't know if I'm profitable. This is one of the big questions we get, is customers come to us and they're like, I don't know if I'm profitable. And oftentimes this is the source of the problem, is they're not accurately accounting for inventory and cost of goods sold, and you get this variability and you don't know if you've actually been profitable in that timeframe. Is that fair to say, Brittany?

9:53 Brittany Brown

Yeah. And it's so skewing. Not only in the first month where you over-expensed, but in the future months, when you are selling your product, you might be selling that product at a loss. You might now be discounting it so significantly you're not even profitable on the sale at all. And you don't know that, because in that month you have no costs associated with that inventory at all. As far as you're concerned, you're doing great.

10:20 Brittany Brown

I was explaining this to a class I was teaching at a university the other day. This relationship between sales and the cost of goods sold, it even has its own name. It's called gross profit. And financial statements are designed to actually show you gross profit.

And they were asking me, well, why is cost of goods sold its own expense category? Why doesn't it fall into the financials the way that it normally does? Why does it have its own metric?

10:50 Brittany Brown

And I was explaining to them about how, if you're not selling whatever it is, whether you're selling a product or a service, the principle holds the same. If you're not even making a profit at that gross profit level.

Let me throw out some numbers, I think it makes it easier to follow. Let's say that I have a blanket and I bought that blanket for a hundred dollars, and I'm now going to sell that blanket for 80 bucks. Obviously, if I'm going to take a $20 loss every time I sell that blanket, it does not matter how many of those blankets I sell or how much I have in sales volume. In fact, driving up my sales will only put me out of business faster, because it is absolutely impossible to come back in any way, shape or form from a negative gross profit margin.

11:35 Brittany Brown

If you're not even selling your product or service at a profit, no matter what happens, you will not be sustainable as a business. Versus, I might have small margins. If I sold the blanket for $110, then in theory I could say, if I was to sell millions of these, even though my margins are small the margins would add up and it would cover my overhead and I would be profitable. But I flip it the other direction and I sell it for a $10 loss, driving up sales will only put me out of business faster.

12:00 Cash versus accrual, and finding break even

Stephen Brown

When we were talking, I was like, I'm going to build a spreadsheet. So if you're listening and you want to jump to YouTube and just watch this illustration.

What I did is I've taken a business in three months and I've illustrated doing the cost of goods sold on a cash basis versus an accrual basis, to show how different it is. In January, roughly a million, then a million two in February, then a million four in March. And in the cash basis example I've got a $700,000 inventory purchase in January and then nothing in February and March. And you'll see in this illustration, with a half million dollars of expenses, this is very simplified, this shows me that I've lost money in January and then I've made a ton of money in February and March.

12:59 Brittany Brown

So wait, before you move off of that, I want to just point out. If you guys are looking at this, and it is really worth looking at, he took the entire cost of goods sold hit in January, and then February and March had no cost of goods sold associated with them at all. All right, sorry, go ahead.

13:16 Stephen Brown

Yeah. So to your point, it gives us a skewed sense of reality. We lose money and then we make a ton of money. Which on a cash basis, in terms of cash flow, this may be the case. But not really understanding the economics of your business makes it really hard to make good decisions in terms of your pricing, in terms of the structure of your business.

If we do this the right way, let's say that our cost of goods sold is actually roughly 20% of revenue, you'll see now within this example, I use the same numbers, that I have a consistent amount of net operating income each month. And this is reflective of actually how the profitability is.

13:55 Stephen Brown

And this tends to break people's minds, the whole concept of accrual accounting. But let me use my dumb MBA mind to try and translate.

I don't know if I'm profitable if I do my cost of goods sold inventory accounting using a cash basis model. And so I'm making decisions on pricing and who to hire and warehouse off of bad data, because I don't actually know if my underlying business is profitable. Whereas if I do it the right way using accrual accounting, and actually apply the cost of inventory as it's sold, I'm going to get an accurate picture of my profitability and be able to make better decisions as to whether I can make additional investments.

Would you think that's a fair way to describe it, Brittany?

14:48 Brittany Brown

Yeah. Another thing I would add to that is, a lot of questions we get from clients are things like breakeven. Based on my current overhead structure, what is my breakeven point? And without the cost of goods sold reflected, it's virtually impossible to calculate a breakeven point. It's virtually impossible to understand some of these critical decisions.

Stephen, actually bring up your example one more time, because there's one thing I want to point out for just a second.

15:14 Stephen Brown

Okay, and let's make sure to describe it really well for those who don't want to.

15:17 Brittany Brown

Yeah, for those who are listening. So because we have a rising revenue level, Stephen said we have a consistent net operating income. For anyone who's looking at it, you probably notice we actually have significant rises in that net operating income each month. But that's because if we're following sales, we can see that as we go from $1 million in January to 1.2 in February to 1.4 in March.

15:44 Brittany Brown

One of the other critical assumptions that I think is a very fair assumption to make is that my overhead expenses are staying consistent. So if I have half a million dollars a month in overhead expenses, as my revenue levels grow, we're assuming a fairly consistent margin on the cost of goods sold, which then means that we have more and more money each month to go towards expenses and then net operating income.

I'm just going to throw out this word because it's the right word to use. It's called contribution margin. So basically as my sales go up, I have more and more contribution margin to now apply towards covering my expenses. And as soon as those expenses are covered, all the rest can now go to net operating income.

16:30 Brittany Brown

This picture, which is a really accurate picture of how the business is doing, and a very important picture when it comes to things like, just in a quick glance looking at this, I'm going to guess their breakeven point is somewhere between $600,000 a month and $800,000 a month. So, okay, a little bit lower.

So now you can see, as Stephen does this, he's now able to see, this actually now shows us our breakeven point for this particular business is somewhere between $600,000 and $700,000 a month. Because we are accurately reflecting cost of goods sold, we can now correctly play with these kinds of things.

17:10 Brittany Brown

And now as a business we can begin to make plans, right? If we think we're going to consistently hit at least $700,000 a month, great news, now we're profitable. If we think we're going to consistently hit at least $1.2 million a month, now we have a much better feel of additional spend we can make to begin to, maybe it's time to invest in a new warehouse. Are we going to be okay? What will that do to our general overhead expenses?

And with a consistent cost of goods sold, those kinds of decisions can start to be planned for. But without it, you have no ability at all to see what the financial impact of each month is going to be.

17:47 Stephen Brown

And I think what's confusing about accrual accounting and what we just described and showed, again, if you're lost, flip over to the YouTube and just kind of see the screen share.

What you see in accrual financial statements, in the profit and loss, is not what happened to cash. And so you saw in the example, when I do a cash basis of accounting I have a better sense of what's going on with cash, but I have no good sense of what the profitability of my business model is. And that's where you get into the statement of cash flows and understanding cash.

18:30 Stephen Brown

But you need to understand both. You need to understand where the cash is going, but you need to understand the financial profitability by key areas of your business to understand how to make good decisions. Like Brittany said, what does my break even revenue level need to be? That's where you need this accuracy to understand that. Can I invest in a new warehouse? What's the impact going to be? You can't do that intelligently unless you are doing this inventory and cost of goods sold on an accrual basis.

That's where I think it melts a lot of minds. I would say, keep melting your mind until you understand it.

19:04 Why you can't leave it to your accountant

Stephen Brown

Because you will be a better business person once you do. This is not something that we should leave to the accountants. Because when we do, you are missing out on the insights that this information tells you.

19:15 Brittany Brown

Well, and the other thing is that it's an unfair ask to the accountants. And the reason why I say that is because the accounting around cost of goods sold is literally a downstream effect of all of the operational activities that are happening upstream.

Well, your accountant is not in your warehouse. They're not aware of what's been received. They're not aware of what's been thrown away. They're not watching your return process. They're not checking boxes that are returned to see whether they're resaleable or not. All of this kind of stuff, all of these processes, all of these procedures, all of these controls, these are all the things that are building the financial data of the business.

20:00 Brittany Brown

And to ask your accountant to somehow have access, I mean, really without any additional communication from the client, what an accountant is able to look at without significant engagement from you is, they can probably see what's sold on each channel by quantity, so they can see the SKU that sold and they can see the quantity of what's sold.

But beyond that, the other pieces involved with an accurate financial picture are things like the value associated with each SKU, which is unto itself a complicated process. They can't see, for example, what was returned and put back in stock. They can't see what left the warehouse for any reasons besides sales.

20:45 Brittany Brown

There are so many pieces of this that the accountant is literally unable to complete a picture on without help and engagement from the client, that I would say, don't just not leave it to your accountant. I would say it's a very unfair ask to expect that the accountant is going to be capable of creating an accurate financial picture without a relationship between the two of you, where you are giving them information that they need, and they are asking you thoughtful questions and they are looking for gaps and continuing to ask questions, and you are engaging in that process. Without that, it's virtually impossible.

21:20 Brittany Brown

Another thing I want to say really quick about inventory accounting as well. This is a complicated thing. We have large clients who do not have a handle on their inventory accounting, or even close to it. And we have small clients who have engaged in mastering this journey who have a much better handle on it. And it's flipped as well. We have large clients who have a good handle on it, we have small clients who have absolutely no idea.

So while this is actually a complicated accounting process and a complicated operational thing, the difference between those who succeed at it and those who don't is not sophistication. It's not general IQ. It's not any of those things. It's those who engage in the journey and show up and actually go on the learning curve and strive to improve their operational maturity as a business, and then understand the financial implications of those activities. Those are the clients that are actually leveling up in these things.

22:20 Brittany Brown

So while this is complicated, I would like to just put a shout out. You know what else is complicated? Figuring out how to market online, and how to deal with algorithms on Meta and all of this other sort of stuff, and how to figure out how to bring a product to market, and how to find manufacturers in China and how to communicate and all of that kind of stuff. You know what else is complicated? Starting a business, period.

So every single person within earshot of this podcast has already done many of those complicated things. And this is not beyond you at all. This is absolutely something that can be mastered. It just requires engagement in the learning curve associated with it.

23:07 Stephen Brown

And the reason I wanted to talk about this is the point that Brittany made. We've seen brands, you think it's just a small brand problem. No, no. We've seen brands that are doing tens of millions of dollars and they're not doing it right, and they have a bad sense of their profitability and their inventory balances from a financial perspective.

Brittany, do you want to know who does inventory accounting right? Public companies. Companies that want to get bought, companies that want to have value, right? So you can kick this can down the road, but if you want to get purchased, let me tell you something. Your acquirer will do it right, and they will probably discount your business because you did it wrong.

23:55 Stephen Brown

So I just want to talk through a couple of things. So I buy a hundred thousand dollars of inventory. Where does it go on my financial statements?

24:00 Brittany Brown

So it sits on the balance sheet until you sell it.

24:06 Stephen Brown

Okay, so we put it on a balance sheet. Where does it go on the balance sheet?

24:09 Brittany Brown

Under current assets, just usually a general category called inventory. You can break it out more detailed if you want and track what's in transit and so on.

24:17 Stephen Brown

We'll just keep it basic.

24:19 Brittany Brown

Keep it basic. So let's just assume you have a general inventory asset account called inventory.

24:29 Stephen Brown

It's an asset on my balance sheet. Okay, Dr. Brittany, or Professor Brittany, whatever. I don't know what they call you. What do they call you?

24:34 Brittany Brown

I just tell them to call me Brittany. I'm not into titles.

24:40 Stephen Brown

Your academia career is already off to a bad start. No, actually adjuncts are the best professors. For anybody that's gone to school, you all know that. They live in the real world.

24:56 Stephen Brown

Okay, so I have this hundred thousand dollars of inventory on my balance sheet. Now let's say I sell. How do I take that inventory balance of 100,000 and move it over onto my profit and loss as a cost of goods sold? Talk me through the process of how inventory becomes cost of goods sold.

25:09 Brittany Brown

Yeah. So for starters, let me just back up a couple of steps and talk about what the variables are involved in determining that it was $50,000 that you sold. And by the way, when we say $50,000, we're talking about the cost of the product. We're not talking about what it was sold for.

25:25 Stephen Brown

I'm talking about revenue. Well, let's keep it simple. Let's say we sold $100,000 of retail. And let's say our cost of goods sold is roughly 20% of that number. So 20% of $100,000 would be $20,000. How does $20,000 go from a balance sheet account to a cost of goods sold account? Talk through that process.

25:57 Brittany Brown

Okay. So because you're using a hundred thousand on both the original investment of the inventory and the sales number, I'm just going to clarify this really quick.

So what he's saying is, we bought a hundred thousand dollars of inventory, that's how much we paid for it, that's now sitting on our balance sheet in an inventory asset for a hundred thousand dollars. He's now saying we sold a hundred thousand dollars in sales. So a hundred thousand dollars of sales ran through our channel. We know that our product costs are typically 20%, which means we mark up by five times whatever it is. So basically we buy the widget for $20, we sell it for a hundred dollars.

26:36 Stephen Brown

Correct. What goes into that cost of goods sold?

26:38 Brittany Brown

So basically what we're looking at is the quantity that was sold, and the value that was associated with that product.

If we were to say we sold five of these, and let's say that we gave it a value of $20 per unit, so we take five of them, we multiply it by the cost, five times 20 is a hundred dollars. So that would be the cost of goods sold.

27:10 Brittany Brown

So when you're looking at cost of goods sold, it's really two variables. But getting to those two variables is the tricky part. It really is just two variables. What were the SKUs that sold, by quantity, and what is the value that's associated with that. Multiply those two together, you get cost of goods sold.

And at that point it becomes, if you're doing all of this more manually, meaning it's being calculated in a spreadsheet and you're making this journal entry, it's going to be a debit to cost of goods sold, a credit to inventory.

27:45 Stephen Brown

You're losing me. You're losing me, debits and credits.

27:52 Brittany Brown

All right, so forget the debits and credits. Just know you're basically going to move that value over.

You're either going to tell your accountant, this is the value that's going to be moved over. Or more likely you're going to say to your accountant, this is the value I want you to associate with the SKU. Your accountant is going to go in and say, we sold five of them. They're going to take your, we call it a product cost catalog, they're going to take your product cost catalog and they're going to say, what's the value that they assigned to the SKU? They sold five of them, multiply this by this, we make the journal entry to move it over.

If you're not using an IMS or any of the other things, that's exactly what the process looks like.

28:26 Landed costs, and what doesn't belong in COGS

Stephen Brown

I want to talk about the concept of coming up with that value of that widget, and it's a concept called landed product costs. Can you tell me what landed product costs are?

28:38 Brittany Brown

Yeah. So I think the best way to define landed product costs is to talk first about buy costs, which is really easy to understand.

So buy costs basically means that I contracted with my supplier to buy a hundred units at $5 each. That $5 each would be the buy cost of those units. So a $500 invoice, I bought a hundred of them, they charged me $5 each, I have a $500 invoice. So the buy cost, $5 each.

29:10 Brittany Brown

Where we then introduce landed costs is that, as you guys know, at least most of our clients are now outsourcing manufacturing overseas. So that significantly increases the costs of the product, because now you have shipping costs, you have tariffs, you have transportation fees, and usually there are several legs of the transportation involved in that. You have the overseas shipping, you have the land.

29:38 Stephen Brown

You may have insurance, shipping insurance.

29:42 Brittany Brown

Right. You might have additional packaging that's introduced along the way.

So now you're taking all of those other costs, the idea being that the cost to basically get your product into the warehouse where it's going to be shipped to the final customer, those are all the costs you want to wrap into the product costs. So that $5 per unit buy cost is now going to have all of those additional costs. You may end up with a product whose final cost is significantly more than $5. It might be $13, it might be $20, it might only be $8.

30:20 Brittany Brown

And it might actually change every single shipment based on, this time we ordered 500 but next time we're going to order 3,000, and therefore they're going to give us a better price. Or we're going to have a pretty standard shipping cost that's going to be spread across more units.

This is where it starts to get complicated. You guys can see why. And you already knew this, this is not news to any of you guys really. You already knew all the complications involved in this. But this is where the buy costs and landed costs create complications. Because every time you reorder, in fact your manufacturer may have charged you $5 no matter the size of the order, but depending on how much was in that particular shipping, or maybe it got stuck at a port, or maybe cost of shipping went through the roof because gas prices went up, or we suddenly had a new president and we got a whole bunch more tariffs. You guys know the volatility and variability that is introduced in those additional factors, even if your buy costs stay consistent.

31:30 Brittany Brown

And why does it matter? Should you go through the hassle of tracking landed costs instead of buy costs? If your landed costs are inconsequential, maybe I'm ordering from one city over and I placed my order and the only thing I really have to pay for is some fuel to go over and pick it up and bring it to my warehouse, you're probably fine just looking at buy costs. But the more significant and more substantial your landed costs become, the more important it is to make sure your picture is more accurate.

31:58 Brittany Brown

And even though it is much more complicated, and the steps involved, I mentioned at the very beginning of the podcast that part of what makes this complicated is all the fail points that happen along the way, all of the different steps and phases. We're not just walking into Office Depot and buying something and recording it. We're now talking about multiple phases, collecting costs as we go.

Think about a sticky ball that's rolling down a mountain, and all the costs that it's picking up as it rolls down that mountain. That's probably a really great way of thinking about it. So by the time it finally gets to the bottom of the mountain, it's going to have all of this extra stuff attached to it. And now you need to cut that ball up and identify all the costs that are going to go to each one of those SKUs.

32:40 Brittany Brown

Yes, it is a complicated process. But the alternative to not doing it well and not doing it correctly is the volatility that Stephen and I described at the beginning of the podcast, which is an inability to see what's really happening. And the more significant your landed costs become, the more critical they are to understanding a correct financial picture.

32:54 Stephen Brown

So to summarize. I go through this process of identifying all the costs of manufacturing, importing a product into a warehouse. And I come up with a calculated value per SKU. And then I can take my sales numbers, and I know how many SKUs I sold of XYZ, and I apply those prices, and that becomes my cost of goods sold. And I take that value, I put it on my profit and loss, and I subtract it from my balance sheet, because now I have less inventory value on my balance sheet and it's now on my cost of goods sold. And I'm all good.

33:29 Brittany Brown

That's right. Simple, easy peasy lemon squeezy. There you go.

33:31 Stephen Brown

Yeah. Now if you're already having a meltdown, just call LedgerGurus. You don't need to do this work. There are people that can do this work, like LedgerGurus. We want to help you with that. What we want you to be able to do is understand what this information represents.

33:49 Stephen Brown

Now, one of the things I run into a whole lot, and Brittany is also a CPA, I don't know if you said that, she tries to hide it.

33:52 Brittany Brown

I did not say that, but I am. Man, it is such a burden, let's be honest. It's like having a big stamp on your forehead that says I'm a huge nerd.

33:59 Stephen Brown

She's always trying to tell me how she doesn't want to renew it this year, and I'm always telling her it's good to maintain it.

34:20 Stephen Brown

But one of the things I run into is people putting other things into their cost of goods sold. So I want to talk about what is cost of goods sold and what is not, and why it matters.

So let me talk about what I see people do. I see people putting their outbound fulfillment costs into cost of goods sold. Sometimes they'll put their merchant fees, the credit card fees that they have to absorb, into their cost of goods sold. And as I've learned by hanging around with a bunch of CPAs, that is wrong.

Why is that wrong, Brittany? Why can't I do that?

34:49 Brittany Brown

Well, I can also say, I certainly understand why the temptation is there. Because when we talk about how you're not going to make any profit if you are selling at a loss, I would say that that actually holds true not just at the cost of goods sold level, but all variable required costs for each sale. And there is a word for this, it's cost of sales.

35:15 Brittany Brown

So when you think about selling something, especially in the ecommerce world, oftentimes there are more required costs for that sale that are actually consistently required than just the product cost. If I'm selling on a channel, the channel is going to cost me money, there's no way around that. It's going to be processed through some kind of payment processor, there's no way around that. I'm going to have to ship that product to somebody, there are going to be costs associated with that shipping, there's no way around that.

So there are very specific costs that are required for virtually every sale when you're selling online. I can understand what people are trying to capture, which is, I want to actually understand what my true margins are per sale. And that's a very valuable thing to track.

35:55 Brittany Brown

So when we start talking about why that's not cost of goods sold versus what is cost of goods sold, we're primarily talking about the way that it's defined by GAAP.

36:12 Stephen Brown

And what is GAAP?

36:14 Brittany Brown

Yeah, so GAAP stands for Generally Accepted Accounting Principles, which basically means that LedgerGurus is not the one that makes the rules about what can be included in cost of goods sold and what isn't. It's a nationwide, international standard now, around what can be included in COGS.

And the reason why they're looking for consistency around this is because, when you pull up the financials of a business and you're trying to decide whether or not you're going to invest in that business, if you are not comparing apples to apples it becomes much harder to make those kinds of decisions. So in general, as an investor, I would rather invest in a product that has better margins than one that doesn't.

36:55 Brittany Brown

And so if there's wiggle room on what's included in COGS, when we know that gross profit margin is one of the most important metrics of success for a business, and this company over here is including in COGS these things and this company over here is not, then it does become very hard to compare apples to apples.

Or if I'm a publicly traded company and I'm trying to make my financials look more rosy, in one reporting period I might include outbound shipping costs, but the very next reporting period, if I'm trying to make my gross profit margin look better, I might drop those outbound shipping costs.

37:39 Stephen Brown

And that's a no-no.

37:41 Brittany Brown

Right, and that's a no-no. So the reason why it's defined tightly is for consistency, and for basically following GAAP.

But I actually agree with the idea that cost of sales is the second most important thing for businesses to be tracking, especially in this landscape. And for the product business that Stephen and I own, Solé Toscana, we do track cost of goods sold according to GAAP, but then we do actually group every other thing into a subcategory that's broken out called cost of sales, so that we could then do a quick calculation to see. We need to coin a new phrase for it. If gross profit margin is sales minus cost of goods sold, what would be sales minus cost of sales?

38:28 Stephen Brown

Contribution margin.

38:30 Brittany Brown

Contribution margin, that's true, I guess. But it is your contribution margin.

38:37 Stephen Brown

But they don't have it structured on your financials. For whatever reason, the Intuits and the Xeros and all those, they didn't make that. That's a calculation you have to do, your accountant has to do, to come up with that contribution margin. And it's very important, but you shouldn't be stuffing it into your cost of goods sold, because then that's going to mess up what your gross profit and gross margins are, and it's going to make you look bad.

38:57 Stephen Brown

And let me translate this whole segment. People with money, with lots of money, understand GAAP, and they're going to look at your financials. And if you're doing it wrong, they're going to get the wrong message.

So this is why, whether it's LedgerGurus or your accountant says we need to do it this way, this is why it's a better way to do it. Because it's a standard, and then people can understand what they're looking at. You don't have to go back and say, well, we like to put this in cost of goods sold. No. You want to do it as close to generally accepted accounting principles as possible, so that people can understand what they're looking at and you can get the best outcomes with your investors, acquirers, lenders, et cetera.

39:44 Brittany Brown

Right. Plus you are actually arbitrarily reducing your margins when you add all these extra costs. So if your investors are coming in and they're looking at what your gross profit margins are, and you've got all these additional costs that are going there, even though I agree from a management perspective it's really valuable information for you with making decisions, it does make your margins look worse than they really are.

So if they're comparing apples to apples and they're looking, am I going to invest in this business or am I going to invest in this business, am I going to acquire this business or am I going to acquire that business, the one with better margins is always going to look like the better option.

40:18 What good gross margin looks like

Stephen Brown

I want to do a little bit more show and tell. So if you didn't go to the YouTube yet, here's another example.

I took some data from Yahoo Finance of three publicly traded consumer product companies, and I want to illustrate what good cost of goods sold and gross margin is. So let me just read it. We've defined cost of goods sold. Your gross profit is your revenue minus your cost of goods sold. And your gross margin is your gross profit divided by your revenue.

40:50 Stephen Brown

Now in this example I have Nike over five quarters, and you can see that the gross margin is almost always the same. It's 44%, 45%, 45%, 45%, 45%.

When I go in, I do a lot more of the CFO advisory work here at LedgerGurus, so I'm not as good at doing all that complicated calculation, but I know what to do with the numbers once it's done. I know what to look for. And one of the things I look for on cost of goods sold is that gross margin number, which is a ratio of income. Is it fairly consistent? You can see it's almost a flat line. This is what I would expect.

41:30 Stephen Brown

Here's another example, Warby Parker. There's a little bit of variability. Their gross margins over the last five quarters, 54%, 56%, 57%, 54%, 55%. The variability can be a currency exchange issue, it can be, to Brittany's point, maybe you had a little bit higher import costs in one period. But it's pretty close. It should be within a few percentage points of each other. If it's not, there's a story.

42:10 Stephen Brown

So here's one more example, Solo Brands. You can see in this example, in September 2024 it was 42%, and the previous quarters it was 63, 59, 58, 62. As an investor I would be like, what happened? Something's off.

And then I went in and I did some searching, and it looks like they had to write down some inventory. A write down is, you basically say, for whatever reason you take a one-time charge due to restructuring or changes. It looks like they had some issues with one of their brand units and they did a one-time write down of the value of that inventory. I didn't dig into the whole details, but there was a reason behind that.

42:55 Stephen Brown

If you're doing your cost of goods sold right, it's going to look like Nike, or it's going to be almost the same percentage every quarter, off by a little bit. But you're not going to go 40% to 60% to 30%. Something is wrong in your calculation if you're doing that.

43:05 Brittany Brown

Or there should be a clear story that supports it. So in general, for example, we often see gross profit margins dip significantly the last quarter of the year. And that's because clients are discounting their sales significantly. So we would expect to see a lower margin, because the costs stayed the same but the overall sales price dropped quite a bit for Black Friday and holiday discounts. That's a pretty common thing.

Also, if you did an inventory count and you had to make some pretty big adjustments.

43:46 Stephen Brown

The warehouse destroyed a bunch, drove a forklift into a whole bunch of pallets and you can't sell it.

43:51 Brittany Brown

Right. So there should be a story. If you don't have good consistency around gross profit margin, there should be a reason for it. Like Stephen was saying, a publicly traded company was able to clearly say this is the reason why margins dropped. It should tell a story. It shouldn't just be like, well, it's volatility because we have no idea what we're doing.

44:08 Stephen Brown

And we don't know what we're doing, we're dumb.

44:20 Stephen Brown

Let me talk about, because I do a lot of the advisory, the forecasting, the budgeting, that's the kind of stuff that I do. I take the good accounting data and I do something with it.

It's a heck of a lot easier to do financial forecasts. Let me just tell you a little secret about finance guys. We like to take shortcuts. And so if I know that my cost of goods sold is consistently around 20, 21%, I'm just going to project that that's 20, 21%. I'm not going to go through this complex calculation of how many units are we going to sell in this period and this period. So I can take some shortcuts and put my energy to focus on other areas of projections and forecasting that are going to be more beneficial.

45:00 Stephen Brown

If I don't have those good cost of goods sold and I'm like, I don't know what I'm dealing with, it's going to be really hard to make projections that are remotely accurate.

And so there's a downstream effect to doing this right. There's ability to get financing, ability to get sold, ability to understand the health of your business, ability to project accurately what future cash flows and profits might be. And so it just compounds to do it right.

45:26 Brittany Brown

Well, another thing I want to add to that is, inventory is, behind cash, your most valuable asset that you have. And so if you aren't doing this right, you miss a lot of stuff.

So one of the things we tell people is, people ask, well, how am I doing with operational stuff? How is my inventory counting? How well am I doing it right now? What kind of grade would I give myself?

46:00 Brittany Brown

And I think one of the very best ways to grade yourself on this is, when you do inventory counts at the end of a period, how big does your adjustment have to be to kind of go back to a starting point again? If that adjustment is large, and by large I would say over 10% of a total adjustment over the course of a year, it means there are a lot of fail points that are causing issues.

Usually a big adjustment is due to the fact that the inventory that we expected to have in the warehouse wasn't actually what was in the warehouse. Or the values that we had associated with it. Or a lot of things were damaged or maybe stolen, all of this kind of stuff.

46:43 Brittany Brown

So it indicates poor controls over your second most valuable asset, cash being the first one. And so there are a lot of reasons besides just getting the accounting right to actually dig in on this. Because fraud and risks and assets and wastage and poor visibility and overselling, underselling, all of these kinds of things are all related to effective management of inventory. And it's not just about good data, it's also about good management that protects the sustainability of your business.

47:05 Stephen Brown

And I'm going to make one adjustment to what you just said. I've looked at a lot of financials of a lot of ecommerce consumer products businesses. Oftentimes the value of the inventory is more than the value of cash. So much of your assets are locked up in inventory, because you have to. You have to have inventory to sell. These businesses tend to be cash poor, inventory rich.

And so really understanding your inventory, to all the points that Brittany made, you're potentially losing profits by not accounting for this accurately. And if you account for it accurately, you can start to say, something's happening, let's figure this out, let's improve this. That improvement is going to improve your profitability.

47:49 Stephen Brown

All right, I think that's a good place to stop, Dr. or Professor Brittany. If you've made it to the end of this episode, Brittany will give you a certificate of inventory accounting.

How can people reach out to you if they wanted to connect with you?

48:07 Brittany Brown

So probably connecting through our website. We do have a contact form. And if you just say, hey, I'm trying to get ahold of Brittany, there's only one degree of separation between the person who manages and watches those intake forms and me. The salesperson who oversees it and the marketing people are both people I talk to almost every single day. So that's probably the best way, is to reach out through our website and just say, I'm trying to get ahold of Brittany in particular.

Or if you're just trying to get ahold of LedgerGurus, because we've done a pretty compelling job of convincing you why you don't necessarily want to go this journey alone. A lot of other people can help with this as well, but I'm also happy to talk shop.

48:49 Stephen Brown

And if you want to talk to me, Stephen, I'm pretty active on LinkedIn. You can do the same thing. But if you chat with me on LinkedIn on one of my posts, I will respond.

All right. Don't talk to Brittany on LinkedIn.

49:00 Brittany Brown

Do not try to talk to me on LinkedIn, because I get so many messages. I promise you, I will not see it. So I apologize upfront. Voicemails that get left on my phone or messages that get left in a LinkedIn inbox pretty much go to the void.

49:17 Stephen Brown

The void. All right, we'll call that a wrap. Thanks, Brittany.