When reviewing a profit and loss statement, one of the traditional benchmarking metrics is Cost of Goods Sold (COGS). What exactly is COGS anyway? Also referred to as Cost of Sales, cost of goods sold is just what it says it is Ñ the cost of all of the inventory sold during a given period.
Paul Erickson, a colleague of mine at Management One, describes COGS as “the most misleading metric in retail.” He prefers to use Cost of Goods Purchased (COGP) as it more directly relates to cash flow and thus the financial health of the business. COGP is determined by simply subtracting purchases from sales for the same period. Paul’s claim is that using COGS can provide a retailer with a somewhat unhealthy financial perspective since selling very little at full price can result in a very good COGS. Using COGP, on the other hand, relates purchases directly back to cash flow. The following example illustrates the difference between the two.
The Formula At Work
Let’s assume that you bought a new style of 50 pairs of running shoes for the current season. After four months you were only able to sell five pairs of the shoes, but they all sold at full price. Your cost of goods sold would be excellent since the cost of selling the widgets did not require any discounting to generate the sales. Herein lies the problem Ñ you still have 45 pairs that you have already paid for remaining in unsold inventory. The cost of goods purchased would paint a much different picture and it wouldn’t be pretty.
Go FISHing
Not to complicate issues, but it needs to be stated that varying accounting methods will have a bearing on COGS. FIFO and LIFO are the most widely accepted accounting methods and FIFO is the most trusted and easiest to use. Simply stated FIFO Ð or first in, first out Ð assumes that items purchased first, were also the items sold first. LIFO Ð last in, first out Ð on the other hand, would recognize that items purchased last would be the sold first. Whichever method you use, know that there will be a difference in profits and therefore income taxes.
Though clearly not recognized by generally accepted accounting practices, this is where the FISH accounting method comes in to play Ñ first in, still here.
I see this all too often, especially in the footwear business. Has this ever happened to you? A style or styles gets purchased, generally with no regard to the merchandise plan, gets put on the wall amidst the rest of the assortment and ends up getting lost. The style doesn’t sell as it should and for reasons unknown to all does not get returned or marked down. The result Ñ COGS-excellent! COGP-horrible!
The lifeblood of any retail establishment is cash flow and COGS does not take that into account. To add insult to injury, if the item is still in the store at inventory time, you get to pay taxes on merchandise that shouldn’t have been bought in the first place and should have been either stock balanced with the vendor or marked down. This is what is meant by the FISH method of accounting.
Understocked/Overstocked
This may sound as a contradiction in terms, but I see this situation often. When reviewing data at the total company level it often appears at first glance that a store has way more inventory than needed to do the business forecasted for a given time period. However, when you drill down to the class/subclass level what you find is an inventory level void of current, fresh seasonal product that is way below levels sufficient enough to produce planned sales.
As a result, sales suffer and both inventory turnover GMROI are reduced. In addition, unless the merchant is paying attention, open-to-buy is also restricted due to the inventory number being inflated with unsaleable merchandise. If this situation is not recognized and dealt with, no new merchandise is purchased and sales get even worse.
You can also encounter the overstocked/understocked dilemma when stores have broken sizes, discontinued vendors and dated inventory that has not been identified. I refer to this situation as having “a whole lot of nothing.” A store that is operating this way can never achieve its true upside potential.
One simple way of self-checking is to pay attention to purchases. A retailer typically should receive somewhat more than it sells. If not, chances are good that the store is not buying enough new merchandise. If receipts are way over what is to be sold for a given period, the store is most likely in an overbought situation, leading to potential cash flow issues, let alone future markdowns.
Recognize and Fix Mistakes
The solution is clearly to recognize mistakes quickly and take action. Margin is great, but it’s no substitute for CASH. Consider this, would you rather have:
- A store full of aging inventory, decreasing sales, slow turnover, low markdowns and poor cash flow, BUT a healthy gross margin percentage on the profit and loss statement, or
- The potential for higher sales due to tighter inventory levels with fresh new product, OTB for fill ins, off-price merchandise and new vendors and faster inventory turnover (cash flow), even though it may sometimes, but not always, mean sacrificing a few precious margin points?
COVID-caused issues notwithstanding, this shouldn’t be a difficult choice, yet we often see examples of shoe stores choosing option A.
Next time you are complimenting yourself on a healthy cost of goods sold figure, go one step further and simply subtract your purchases from your sales to determine cost of goods purchased. If you are doing it right, you can pat yourself on the back with both hands. If not, we are always here to help.
about the author
Ritchie Sayner has spent the past four decades helping independent retailers improve sales, profitability and cash flow. He can be reached at
advancedretailstategies.com.
