Dude, Where`s my margin? (part 2)

In the first part we looked at a P&L statement and identified biggest cost saving opportunities. Now is the time to look into Cost of Goods Sold and share some of our best practices making it accurate.

Cost of Goods Sold (COGS) - 59 % of sales
When was the last time (if ever) you compared vendor invoices against the costs in your system? Were your expected costs close to the invoiced amounts? Or, maybe, you have a process to actualize your expected COGS using the invoices?

First issue with COGS is that product wholesale costs do not reflect your current pricing.
Once the vendor is set up, products are created in the system and wholesale costs are rarely updated. As sales grow retailer qualifies for additional discounts yet expected wholesale cost for the products stays the same.

Second problem is that your P&L does not reflect actual cost of goods sold.
Let`s take a look at a customer return - one of the scenarios affecting your COGS accuracy:
  • Product is shipped, vendor invoices you for $500, COGS goes up by $500.
  • Customer wants to return the item, vendor authorizes the return.
  • Vendor receives the product, deducts 20 % restocking fee and sends you a credit memo for $400.
In this scenario COGS should be reduced by $500 to it`s original state and $100 restocking fee should be reflected on the Returns account. In practice, COGS is not adjusted and credit memo is not reconciled with the original purchase order increasing some "other sales" account for $400. The very same thing happens with double shipments, damaged in transit etc.

One might argue that this is a small accounting technicality; yet numbers speak for themselves. Returns, damages and other errors constitute 7 % of sales, so COGS is overstated by 7 % * 59 % = 4.1 % of sales.

Running the numbers our way does not increase your Gross Margin but uncovers real issues (returns, shippers` and vendors` errors). Additional benefit - by changing the cost allocation you force yourself to improve the Invoice Verification process. My experience - lack of the "PO - Invoice - Credit Memo" process can result in vendors "forgetting" to issue credit memos. Your losses here can run around 1.5 % of sales or $150K annually for a $10m company.

In conclusion, I would like to like to restate the three problems with COGS and suggest solutions:

Problem:
  • Product wholesale costs do not reflect current discounts and are overstated.
Solution:
  • Collect 6 months of order history, reconcile purchase orders with vendor invoices and update the wholesale costs. Repeat every 6 months.
Problems:
  • COGS line item on P&L is overstated because of returns, damages and double-shipments.
  • You under-collect thousands of dollars in Credit Memos.
Solution:
  • Change the way you account for product costs for returned/ damaged/ double-shipped goods. Implement a per-PO invoice reconciliation process. Get vendors send you invoices in CSV or XLS format to speed up reconciliation.
In the next article I will go into specifics behind the Shipping line on your P&L and suggest a couple of strategies to drive the costs down.

Good luck and have a great Labor Day weekend.

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1 Comments:

Blogger Eric said...

I think a lot of people/firms overlook the complexities involved in retailing. It's great reading about some of those headaches instead of the idealized version.

September 2, 2008 at 9:13 AM  

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