COGS Considerations for E-Commerce Companies
As mentioned in our previous blog post, COGS should be recorded in the same period as the revenue it generated, in accordance with the matching principle and accrual basis of accounting. ASC 606 requires companies to apply the 5-step revenue recognition principle to transactions with customers and directs companies to recognize revenue when earned. For e-commerce companies, both revenue and COGS must be recognized when the product has shipped.
This sounds simple in theory, but is difficult in practice as many e-commerce companies have business models that involve other parties. For instance, many e-commerce companies leverage a dropshipping business model, in which the company relies on external vendors to fulfill customer orders instead of holding inventory onhand. Many retailers prefer this business model because they do not wish to bog down their balance sheet with inventory that is quickly obsolete. While the customer does business directly with the e-commerce company, the 3rd-party fulfillment company must source and ship products to customers on behalf of the e-commerce company.
The challenge for accountants begins with the fulfillment phase as they start to lose control of the timing of the shipment. Shipment date is a critical datapoint to e-commerce accountants because that is when revenue and COGS can be recognized.
To ensure revenue and COGS are reported in an accurate and timely manner, accounting must collaborate cross-functionally with the supply chain team - the liaison between the company and its various suppliers. Sources like dashboards, real-time processing, and integration with vendors’ systems allow e-commerce companies some visibility into customer orders statuses.
Visibility Into COGS Will Benefit Your E-Commerce Company
- Particularly for companies with high transaction volume, real-time visibility into COGS numbers enable you to negotiate payment terms and incentives with vendors. Volume discounts can not only improve your margins but also enhance your cash flow if your volume discount is a cash rebate.
- Cash forecasting and budgeting become more accurate with COGS visibility. Ability to cut and slice COGS into current vs. prior period amounts is key to accurate financial reporting. Monthly accruals and timing issues can skew margins and knowing what’s truly related to sales and what’s correcting prior period errors creates added reliability for budget and forecasting purposes.
- Understand where your money is going. When COGS is not aligned with expectations, everyone from accounting, supply chain, accounts payable, to sales must be involved. It’s a collective effort to tell the story of what happened with COGS. Did accounting miss an accrual or over accrued expenses? Did finance or sales estimate the wrong product mix? Or is it a technology issue in which our systems did not sync with vendor systems? COGS analysis drives these conversations so that employees and management are aligned on the drivers behind COGS fluctuations.
System and Technology Challenges
As businesses evolve, its systems must also grow to handle the increasing complexity and scale. If your financial systems do not "talk to each other" and there are no smooth API-integrations, accountants are always left with the manual work of ensuring the systems match.
How do your existing financial systems handle variables such as shipping delays, returns, and missing vendor invoices? Or what about when sales impact multiple periods and you need to match COGS with revenue? Are there necessary data integrity controls in place to surface recurring issues or does the accounting team need to scramble last minute at month-end?
Especially for e-commerce companies, robust finance technology stacks that provide real-time, ongoing communication internally and externally with vendor systems is of utmost importance.
There's a lot of emphasis on net income or the "bottom line" when decision-makers need to have an in-depth discussion about COGS. COGS is the best indicator to show how much a company had to spend for each dollar of revenue earned. Without accurate and timely COGS numbers, it's almost impossible for executives to make the right decisions for the business. Companies must make the appropriate investments in systems, talent, and processes so that COGS analysis adds value to the forecasting and strategic direction of the business.