Inventory and COGS for Shopify | How to Do It Right!

I'm Stacy with LedgerGurus, and I work with business owners every day who are struggling to understand profitability and their margins. My goals for this video are to give you a general overview of COGS and inventory and to help you create a roadmap to do it correctly. I'll first discuss why inventory and COGS is so important to track correctly. Second, what is COGS and what is included in it? Next, we'll talk about common problems with inventory accounting and how inventory and COGS moves through your financials. And last, how to successfully manage COGS.

1:07 Why COGS drives your gross profit

Inventory is such a key part of the success of your ecommerce business at every stage. So setting things up correctly from the beginning helps you from an operational perspective to mature your business, making it easy to get the financial data that you want and need.

So you might ask yourself, why is inventory and cost of goods so important to track? Well, cost of goods sold is the cost of the product that you actually sold. This is the top part of your profit and loss statement if it has been set up correctly. You have sales, which is pretty self-explanatory. It's whatever you've sold. And underneath that is an important expense category called cost of goods sold. So sales minus cost of goods sold gives you your gross profit. This is really your margin on your product.

1:55

The reason you want to set your financials up this way and track your data correctly is because the gross profit is the most important metric you will watch as a product business. Is your profit growing? Is it declining? Is it holding steady? This will be the most important metric for you to watch in order to manage the profitability of your business correctly.

So as you can see, the cost of goods sold is the most important expense. It's one of the two categories, sales and cost of goods sold, that helps you get to gross profit. So if you're doing this wrong, you can easily skew your results.

2:39 The rookie error and the like a boss method

So what do I mean when I say doing it wrong? I'm going to show you what I call the default rookie error. This is what people tend to default to when they don't really know how to handle accounting around inventory correctly. The short explanation is when they purchase inventory, they expense it immediately.

Here is an example of how this affects the financial statement. Here is the top part of the profit and loss, like what I just showed you. We have income across the top, except this time I have broken it out across three months. In this case, in the month of January, I bought a bunch of product and it's now in my warehouse. In the first month that that hits, I expense it all right away, so that what I end up with is a $15,000 gross profit loss in the month of January, and then I have February and March living their best lives with no burden from cost of goods sold.

So January is taking all of the responsibility while February and March are not carrying their weight. But what that really means is you have no idea how your business is doing, and you show this extreme volatility around gross profit and you really have no idea how you're doing with your margins.

3:52

When this is done correctly, this is what it should really look like. I call this the like a boss method, because this method gives you such better results. I want to be clear that this method does take a bit more work, but it's still the correct way to do it.

In this case, we still have these same months with the same revenue levels. Only this time we're expensing the cost of our product incrementally according to how it was actually sold. So in this first month, we have 15,000 in COGS, then 10,000 and then 20,000 in COGS.

What you see here is that you have a consistent gross profit margin month over month. You can see how you're performing as a business and you can see what your profitability really is, and you can make really good decisions with this method. In order to use the like a boss method, it requires you to set things up in a thoughtful way operationally. That's what I want to walk you through today.

4:52 How inventory moves through your books

I want to skip to the end for just a minute so you can see what's happening to inventory. How am I able to expense it incrementally over time? If I'm not expensing it right away, what exactly does that look like?

So this is your balance sheet and your profit and loss statement. When you first buy inventory, instead of expensing it right away, which would hit your profit and loss, instead it becomes an asset for you on your balance sheet. Instead of expensing it through COGS, you code it to inventory where it sits as an asset, which it is.

In this situation, this is what it looks like when we buy inventory. You can see how we have $300 worth of inventory on our balance sheet and we have nothing in COGS, because we haven't sold it yet. When you sell the product, you basically take whatever the value of the product was. Let's just say it's $50. That inventory moves from inventory on the balance sheet and is expensed through COGS incrementally as the product is sold.

So this is what it looks like, how it moves through your financial statements, and this is what the journal entry looks like in QuickBooks Online. It becomes a credit to inventory, which reduces inventory, and becomes a debit to cost of goods sold. This is what the end result looks like. So let's go back and talk about how we got there.

6:15 Bernie's Bikes and the product cost catalog

In order to successfully manage cost of goods sold and the movement of inventory from inventory on your balance sheet to COGS as an expense on your P&L, you need to be able to track two things: the quantity of your inventory, so how much you have of each SKU, and the value of that inventory by SKU. So what does that look like? How do you track the value of your inventory?

Let's use the imaginary business Bernie's Bikes for our example today. Bernie's Bikes purchases bikes and gets an invoice from their vendor for $5,000. This invoice is a gold mine of information. It shows that Bernie purchased two green road bikes for a thousand dollars each, two orange cruisers for $500 each, and eight red tricycles for $250 each. This helps Bernie see the value of each of his SKUs individually.

As a side note on this video, I'm making the assumption that you are purchasing a finished product from your vendor, not doing any kind of manufacturing, but these same principles apply whether you're building it yourself or buying it from a vendor. You want to be able to say when you're done, this is what I have. This is the quantity that I have, and this is the value associated with it.

7:34

So now I'm going to take all of this information from the bill and I'm going to build what I call a product cost catalog. In this product cost catalog, I now see that I have two green road bikes valued at $1,000 each, two orange cruisers valued at $500 each, and eight red tricycles valued at $250 each.

As your product comes in, as you buy more orders, as you buy more inventory, you're constantly updating your product cost catalog. Now, if you're ordering under circumstances where your products stay pretty stable and you aren't really looking at landed costs, you could really just establish your product cost catalog, look for reasons it could change, and then basically leave it the way it is. But this is what a product cost catalog basically looks like.

On a side note, we have another video that goes really deep on product cost catalogs. You can find the link in the description. It helps you understand how to build, update, and use a product cost catalog. But for the purpose of this video, I just need you to know that having a product cost catalog is a really important part of this process.

8:42 The quantity equation

The other thing you need to know is that in order to assign value to your inventory, you need to be looking at the quantity of the inventory times the value of it. When I talk to sellers and ask them if they're tracking their inventory, they often say, of course I'm tracking my inventory. But nine times out of 10, they're referring to tracking the quantity of their inventory, which is really important. But I need them to track not only the quantity, but also the value of the inventory.

The quantity of inventory is typically the easy part of this to track. It's done with a simple math equation. Basically, you start with your beginning inventory and then add to that whatever you purchase during the timeframe, and then subtract from that everything that sold during that same timeframe. That gives you your ending inventory. So if I begin with 20 and add another 10 and then I sell five of them, my ending inventory is 25. This is the way that inventory moves through your overall business.

9:42

But what we're really trying to get here is cost of goods sold. So in this case, beginning inventory is easy to see, purchases are usually easy to see, and ending inventory is easy to see. So I'm going to swap this equation so that what we're solving for is COGS, which is the harder part. So in this case, I'm going to say beginning inventory plus purchases, minus ending inventory, equals cost of goods sold.

So in this case, we started with 20, added 10. We found now that we have 25 left, which means we sold five in this time period. So this is a simple way to go about tracking inventory quantity if you don't have a system in place to track it every time a sale happens. Incidentally, if you keep your quantities updated in Shopify, you can pull this information from your Shopify sales report.

10:36

Now remember I said that COGS comes from saying, what was my quantity times what was my value? So in this case, I'm going to take the same numbers that we had and I'm going to assume that we have a product that only costs us $10. So 20 units times $10 gives us $200, 10 units times $10 gives us a hundred dollars, and so on. You can see clearly what's happening.

The cost of goods sold number is what I'm really trying to get to here. This number is the number that moves from my balance sheet onto my profit and loss based on how many units sold. So this is really what I'm trying to get to here. How many units did I sell and what was the value assigned to each unit, which equals your cost of goods sold.

11:23 Shopify as product master and recap

If you are selling on Shopify and using the backend to keep track of quantities, then this whole process can become easier in many ways, because Shopify can also become what I call the product master.

So product cost catalog, which I mentioned earlier, is where you have your products with costs assigned to those products. But the product master is what basically says, this is the inventory I have available and this is the movement of my inventory. People often use an inventory tool that works as a product master, and those tools communicate to all of your sales channels how much inventory you have available. But if you're only selling on Shopify, you can use Shopify as your product master.

12:09

So let's circle back and do a quick recap. In this case, we bought our product and instead of expensing it right away through COGS, we put it in inventory on the balance sheet. Then during this time, we maintain the product cost catalog and the product master. Then we take that and say quantity times value of what was sold during that time gives us cost of goods sold. In this case, we're saying $50 of that was sold. So $50 goes from inventory through over to the cost of goods sold. This then becomes our expense that allows us to see our margins, see how our business is doing, and operate from an informed place. Here's what the journal entry looks like.

12:49

If you are managing your inventory with Excel, we have an inventory and COGS template that will help you do all of this quickly and easily. There are sections for quantity reconciliation, COGS computation, physical inventory valuation, and a product cost catalog. We have included a video that will walk you through how to use it. The link is in the description below. You can also go to our website ledgergurus.com for more valuable information about how to handle all things accounting for your ecommerce business.

If your inventory management is getting too complicated for a spreadsheet and you're ready to investigate how to automate your inventory processes, talk to us. We implement inventory management software tools all the time, and we focus on making sure that your inventory management software and your accounting software are talking to each other properly, so you can trust the data coming out of both of them. The link to our services page is in the description below.

Thanks so much for watching today. Hit that like button and subscribe, and be sure to comment if you have any questions. We'll catch you on the next video.