Cost of Goods Sold, Gross Profit, and Gross Margin
The next concept that we need to understand is costs of goods sold (COGS) or cost of sales. Cost of goods sold indicates the cost of the goods sold during some time period (i.e., one month or 0ne year) and can be defined in several ways. COGS can be defined as the difference between goods available for sale and ending inventory. COGS can also be defined as the direct costs attributable to the production of goods sold, including the costs of materials used in creating the goods and the direct labor costs to produce the goods. COGS excludes business operating expenses like salaries, rent, utilities, and sales commissions. The exact costs included in COGS differs from one type of business to another.
Since we are interested in online retailing we can use a much simpler definition. For retailing, the cost of goods sold is the price paid for the product plus additional costs necessary to get the product into inventory and ready for sale, including shipping and handling. When drop shipping, the wholesale suppliers price you pay plus the drop ship fee, if any, and any postage and handling equals the costs of good sold. If you buy bulk from the wholesaler and have the items shipped to you business then the cost of goods sold would be the whole sale cost of the product plus the cost to ship the product to your business and any shipping and handling costs to ship the product to your customer. If you use multiple product sourcing methods then your COGS is the sum of all methods used.
Drop shipping: COGS = wholesale price + drop ship fee + shipping & handling cost
Bulk purchase: COGS = wholesale price + wholesale shipping & handling + customer shipping & handling
Another way to determine your COGS is with the periodic method. Using the periodic method, COGS is equal to your inventory at the start of the period plus purchases made during the period less inventory at the end of the period.
Gross Profit
Once we know our cost of goods sold we can calculate our gross profit. Gross profit is simply the difference between our total revenue and our cost of goods sold. This tells us the total (gross) profit we’ve made. You need to make sure our gross profit is the same or higher than our operating expenses or our business will be losing money. I will discuss operating expenses in my next post.
Gross profit = revenue – cost of goods sold
Gross Margin
Gross margin is very similar to profit margin and they are calculated using the same basic method. The key difference is gross margin uses total revenue and cost of goods sold from all of your sales while profit margin is revenue and cost from single sales. Another way for view them are: gross margin is the average margin for all of your sales. Profit margin is the margin for a specific sale.
Gross margin = (total revenue – total cost of goods sold) / revenue
One thing I forgot to mention in the post Wholesale Markup versus Profit Margin was that markup and margin have an inverse relationship. This means that you can easily calculate one if you know the other.
Wholesale markup = 1 / profit margin
Profit margin = 1 / wholesale markup.
The same calculations can be used to determine your average wholesale markup. The average whole markup would be equal to 1 / gross margin.
| Example Calculations |
|||||||
| Total Sales | $100,000 | ||||||
| Less Returns | -$1,500 | ||||||
| Net Sales | $98,500 | ||||||
| Cost of Goods Sold | |||||||
| Inventory, Jan 1 | $30,000 | ||||||
| Purchases | $50,000 | ||||||
| Less Returns | -$500 | ||||||
| Less Discounts | -$1,500 | ||||||
| Less Purchases | -$2,000 | ||||||
| Net Purchases | $48,000 | ||||||
| Freight In | $1,500 | ||||||
| Costs of Goods Purchased | $49,500 | ||||||
| Goods Available for Sale | $79,500 | ||||||
| Less Inventory, Dec 31 | $25,000 | ||||||
| $54,500 | |||||||
| Gross Profit | $44,000 | ||||||
| Gross Margin | 44.67% | ||||||
| Average Markup | 69.12% |
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