Increasing sales isn't necessarily the best way to improve your bottom line. A better solution might be to reduce the cost of goods sold.
Paying less to purchase the products you sell can translate into higher gross revenues and higher profits, even if the amount of products you sell remains the same.
If you're ready to make more money without selling more products, here's a summary of the COGS and specific cost-cutting strategies.
A brief summary of the cost of goods sold (COGS)
What do the goods sold cost?
The cost of goods sold (COGS) includes all costs of making and purchasing the products you sell. You can divide COGS into two parts: direct and indirect costs.
Direct costs are the costs incurred in making the products you sell. They include:
- Raw material costs
- Labor costs during production
- other production overheads
- the cost of wholesale products
Indirect costs are all other costs that are incurred in the manufacture of products that are not directly tied to the process. They include:
- Packaging costs
It is also worth clarifying what COGS is not.
For example, your COGS does not match your operating costs. Both are expenses, but operating costs (also known as OPEX) are not tied to the production of your products. Instead, they include costs like rent, utilities, marketing, and legal.
They are also not the cost of sales, as this infographic from EDUCBA shows.
How do I calculate the cost of the goods sold?
Organizations can calculate COGS using a standard formula that takes into account inventory levels and all of the direct and indirect costs listed above.
COGS = open inventory + purchases during a period – close inventory
- Open inventory is the value of the inventory you hold at the beginning of a certain period of time (such as a fiscal year).
- Product purchases and any resulting costs (as listed above) will be added to the opening inventory.
- Closing stock (the value of products that were not sold at the end of the period) is subtracted from this total to calculate the final result Cost of goods sold.
Here's an example:
For example, let's say we want to calculate the COGS of an e-commerce brand in fiscal 2019. The opening inventory would be the inventory recorded at the end of fiscal year 2018. Let's say it's $ 2 million.
The final inventory would be the inventory recorded on the company's balance sheet at the end of fiscal year 2019. Let's say that's $ 3 million. Eventually, the company bought $ 5 million in inventory in fiscal 2019.
The COGS for the 2019 financial year is:
2 + 5 – 3 = $ 4 million
The COGS is $ 4 million.
If you'd like to see what the calculation of COGS looks like in the real world, Investopedia provides an example based on J.C. Penney.
The calculation can also change depending on how you define the closing inventory. There are three options:
- FIFO (first in, first out): The first item you add to your inventory will be the first to sell. This option minimizes the COGS as long as the price continues to rise.
- LIFO (last in, first out): The last item to add to your inventory will be the first to sell. When prices go up, this maximizes the COGS and reduces profit.
- Average costs: The cost is taken as an average and provides a balance between FIFO and LIFO.
Why should I think about COGS?
COGS is an important line on your balance sheet. If you do this, you can:
- Improve profit margins. Knowing how much you are spending on products can help reduce your ecommerce overhead.
- Identify profitable products. By calculating your COGS, you can determine which products are the most profitable and which are not.
- Price exactly. Knowing your COGS will help you rate your products better. Knowing the cost of every product you sell can ensure that you are pricing in a healthy margin.
- Be taxed appropriately. COGS is a business expense that is deducted from your total sales. In other words, you will not be taxed as it is a business expense. This could be the only reason you think a higher COGS is a good thing. Remember, however, that a higher COGS means less sales and therefore less profit.
7 tips to reduce COGS
Now that you are on the cutting edge, it is time to get to the heart of the matter and see how you can reduce your company's COGS.
Below, I've outlined seven strategies that almost any business can use.
1. Stop making products that aren't being sold
Do you have a large amount of inventory in your warehouse? These are products that have not yet been sold and are unlikely to be sold in the future. If so, they could destroy your margins and add massive amounts to your COGS. Remember, the COGS calculation takes into account the inventory you have at the beginning and end of your billing cycle. It doesn't matter how long it sat there: it will be included in the calculation.
Deadstock isn't great, but there is an easy way to make sure your COGS doesn't increase in the future: stop making products that won't sell.
Of course, no business owner intends to make consumers hate a product, but it does happen. Even the largest companies have flops every now and then. New cola, anyone? I didn't think so.
Don't worry about creating the wrong products, just identifying products that aren't selling well. Use inventory management software to identify products that are in the back of your warehouse.
Encourage customers to review your products for real-time feedback from the most important people. Then act quickly. Once you identify a poorly performing product, take action to reduce production or stop sales altogether.
2. Find cheaper materials
Material costs are probably one of the largest components of your COGS. There is usually no shortage of material suppliers, so you may find cheaper products elsewhere.
Purchasing materials from different suppliers is one solution, but you can also consider replacing part of your finished product with a cheaper alternative. You may think that your customers love the sturdy metal used in your product, for example, but they might be just as happy with a plastic substitute.
It may also be worthwhile to reconsider the technology used in manufacturing to see if new processes can use cheaper materials.
Whichever strategy you use, be careful not to use cheaper materials at the expense of your end product. Providing a consistent experience is one of the best ways to build trust with your brand and customers expect to get the same product every time.
Even loyal customers can quickly switch to competitors if your products don't meet their expectations. A drop in sales can be far more significant than any savings you've made by switching materials.
However, this is not the only downside to consider. Inferior materials can also reduce the shelf life of your product. Changing materials may require a change in the manufacturing process. This could increase production overheads or labor costs to such an extent that the saved costs are canceled out.
3. Eliminate costly waste
There has to be waste somewhere in your supply chain. For example, your manufacturing process can be inefficient and waste a lot of raw materials. You may even have to pay to dispose of them. Shrinkage can also be significant. This happens when products are damaged, stolen, or lost.
Waste doesn't have to be physical. There could be a lot of time wasted in the manufacturing or shipping process that could be reduced to improve your COGS. Downtime can be expensive, whether in the factory or at sea.
Investigate any physical or other waste in your supply chain and take action to reduce or eliminate the most expensive culprits.
One strategy could be to redesign the manufacturing process when material waste is significant. Another option is to change shipping arrangements if the shrinkage is high and many products arrive damaged.
4th Automate parts of your business
Work can be an integral part of your COGS. Fortunately, you may be able to automate some of these expenses. Any part of the manufacturing or shipping process that you can replace with a machine can save enormous costs. Machines are usually cheaper to run in the long run, there is less risk of failure, and there is virtually no downtime.
When you've done your part, ask your supplier. Encourage them to invest in automation to cut costs, if they haven't already. You may even be able to use this as part of a negotiation strategy as explained below. If they're not ready to play ball, consider switching to another provider that invests in automation. If they're not cheaper now, they could be cheaper in the future.
5. Investigate offshore manufacturing
Manufacturing in the United States (or your country of origin) can often be a big selling point. It can also be incredibly expensive. This is why so many of the world's biggest brands are outsourcing manufacturing operations to countries like China, Taiwan, and Vietnam.
Both raw material and labor and utility costs are often much cheaper in these countries than they are at home, which means your business can save in a variety of ways. Even if you factor in increased shipping costs, your COGS can still go down if manufacturing is outsourced.
However, this strategy should only be considered by large companies. The upfront costs can be significant and the risks involved.
For example, quality issues may arise and you may have to deal with PR issues due to the working conditions in these countries. Currency fluctuations and tariffs can make things even more complicated.
For some companies, however, the opportunity to drastically reduce their COGS is worthwhile.
6. Consider manufacturing on demand or dropshipping
One of the biggest drivers for COGS is inventory purchases that are made all year round. The more products you buy, the more costs rise.
Instead of stocking products that might not be sold, brands could reduce their COGS through an on-demand strategy. Essentially, you only make or order products when a customer has already paid.
Print-on-demand websites like Printful and Dropshipping are two of the most common ways to use this strategy.
With Printful, products are printed in real time as soon as an order is placed. There's not even a minimum order limit.
It is similar with dropshipping. Companies only pay for products when the customer pays for them. Either way, items can be shipped directly to customers so stores don't have to keep inventory.
7. Negotiate with everyone
You can and should negotiate prices regularly with every company in your supply chain. The prices you pay suppliers are a central part of your COGS. Reduce it and your COGS will decrease too.
When I say every company, I really mean everyone. Manufacturers, raw material suppliers, logistics companies, storage facilities and wholesalers can offer you a lower price on request.
Here are some offers you might ask for:
- lower unit prices
- Volume discounts
- Lower prices in return for faster payments
- Lower prices in return for prepayment
- lower minimum order requirements
Remember, negotiation is a two-way street. While some companies are willing to cut prices just to keep your business going, others need something in return to sweeten the business. For example, improving payment terms is always a useful bargaining chip.
It's also important to remember that your negotiations can have unintended consequences. For example, asking for volume discounts means you need to store more products and see a cost increase that can dwarf your savings. If you're asking lower prices in return for faster payments, you may need to improve your cash flow.
Think carefully about what you are asking for and make sure you can handle the consequences of your negotiations. The last thing you want to do is forego a deal because you negotiated badly.
Increasing your sales is essential, but so is reducing your company's COGS. Whether you want to bargain hard with suppliers, reduce waste, or automate your processes, try to cut costs in every possible way.
I've given you seven strategies to get started, but there are always more ways to cut costs.
What innovative ways to cut costs have you found?
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