Understanding Retail Metrics: Why Cost of Goods Purchased Trumps Cost of Goods Sold

Cost of Goods Sold VS. Cost of Goods Purchased

When reviewing a profit and loss statement one of the traditional benchmarking metrics is Cost of Goods Sold. What exactly is COGS anyway? Also referred to as Cost of Sales cost of goods sold is just what it says it is the cost of all of the inventory sold during a given period.

Paul Erickson’s Perspective

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 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.

Illustrative Example

The following example illustrates the difference between the two.
Let’s assume that you bought a new style of 50 pairs of hockey skates for the current season. After four months you were only able to sell 5 pairs of the skates but they all sold at full price. Your cost of goods sold would be excellent since the cost of selling the skates did not require any discounting to generate the sales. Herein lies the problem…you still have 45 pairs that you have already paid for remaining in unsold inventory. The cost of goods purchased in this example would paint a much different picture and it wouldn’t be pretty.

Accounting Methods and Their Impact on COGS

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.

FIFO vs. LIFO

Simply stated FIFO or first in first out assumes that items purchased first were also the items sold first. LIFO (last in first out) on the other hand would recognize that items purchased last would be sold first. Whichever method you use know that there will be a difference in profits and therefore income taxes.

The FISH Accounting Method

Though clearly not recognized by generally accepted accounting practices this is where the FISH accounting method comes into play—first in still here. I see this all too often. Has this ever happened to you?

• A style or styles gets purchased generally with no regard to the merchandise plan.
• It 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… 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:

• a) shouldn’t have been bought in the first place and
• b) 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

Inventory Challenges in Retail

I know this may sound like 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 and 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.

The Overstocked/Understocked Dilemma

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.

The Solution

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
• 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 mean (but not always) sacrificing a few precious margin points?

Covid-caused issues notwithstanding this shouldn’t be a difficult choice yet we often see examples of stores choosing option A.

Next Steps

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.

Ritchie Sayner

Ritchie Sayner

See Full Bio