Inventory and COGS: why your P&L is lying about margin

Here is a P&L that looks healthy and is lying to you.

Cost of goods sold means the cost of the goods that were sold. Inventory
purchases means the cost of goods that arrived. In a business that buys in
batches and sells continuously — which is every ecommerce business —
those two numbers are almost never the same, and in the month you place a large
order they are wildly different.

Booking purchases as COGS does not make your margin slightly wrong. It makes it wrong in a different direction every month, which is worse than being consistently wrong.

What it does to your numbers

Same business, same three months, recorded both ways. In March a big
restocking order landed; in April almost nothing was bought; in May, normal
trading.

The right-hand column is the truth: a stable business running at about 58%.
The left-hand column is what the owner sees, and it is unusable. You cannot spot
a supplier price rise, a shipping cost increase, or a product that has quietly
stopped making money, because the monthly noise is forty times larger than the
signal you are looking for.

The three things this hides

Your inventory is not on the balance sheet

If purchases go straight to COGS, the stock sitting in your warehouse or in
an FBA facility is worth nothing in your accounts. For many ecommerce
businesses inventory is the largest asset they own. A balance sheet showing none
of it understates the business to any lender, buyer or investor who reads it
— and it means you have no book figure to check a stock count against.

You cannot see which products make money

Aggregate COGS tells you the business made 58%. It does not tell you that
three SKUs are at 70% and one is at 11% and consuming most of your ad budget.
Product-level margin needs cost tracked per unit sold, and that is impossible
while cost is recorded per delivery received.

Your tax position can be wrong

Inventory is an asset until it is sold. Expensing purchases on receipt
overstates costs in a heavy buying period and understates them later. Where a
business is on accrual accounting, that is not a timing preference — it is
a misstatement, and it changes the tax due in each year. This is worth a
conversation with whoever prepares your return, not a decision to make alone.

How to do it properly

Three moving parts, and none of them is difficult:

1. Purchases go to inventory, an asset account — not to an
   expense. Include landing costs: freight in, duty, and inbound shipping are
   part of what the goods cost you.
2. At month end, move the cost of what sold from inventory to COGS.
   Units sold × unit cost. If you sell 400 units that cost $9.40 each,
   $3,760 moves.
3. Count the stock periodically and adjust to the count. The
   difference between your book figure and the physical count is shrinkage,
   damage or a costing error, and it is information worth having rather than a
   nuisance.

Which unit cost method to use

Most small ecommerce businesses use weighted average cost, and for most of
them it is the right answer: it is simple, it is stable when supplier prices
move, and it survives having the same SKU arrive at three different costs. FIFO
is more precise and more work, and matters most where unit costs are high or
moving sharply. Whichever you pick, the rule that matters is to pick one and
stay with it — a margin computed one way this month and another way next
month is not a comparison.

Questions we get asked