HTS Code Explained: What It Is, Why It Matters, and How Ecommerce Brands Use It

Cost of Goods Sold (COGS) represents the direct costs attributable to producing the goods a company sells during an accounting period. COGS is a business expense reported on financial statements and is deductible for income tax purposes, reducing taxable income. For ecommerce brands, this seemingly straightforward accounting concept becomes operationally complex when founders must decide whether shipping upgrades, returns processing, custom packaging, and 3PL fulfillment fees belong in COGS or operating expenses. The classification matters because gross profit (revenue minus COGS) determines whether your business model actually works at a unit economics level, while operating profit (gross profit minus operating expenses) tells you whether your overhead structure is sustainable. To calculate gross profit, subtract COGS from total revenue.

The stakes are meaningful. Ecommerce brands averaging 35-40% gross margins who incorrectly exclude $8-12 per order in fulfillment-related costs from COGS may believe they’re profitable when unit economics are actually negative. This misclassification postpones critical business model corrections until cash reserves deplete, making COGS calculation accuracy an operational priority, not just an accounting exercise. Accurately calculating COGS is essential for tax planning and managing tax liability, as an accurately calculated COGS helps businesses manage their tax liability effectively. Knowing how to calculate COGS and calculate cost is also important for financial modeling and inventory management. COGS is critical for determining gross profit, guiding pricing strategies, and informing tax calculations.

What COGS actually means in an ecommerce context

COGS encompasses all direct costs tied to producing or acquiring the inventory sold during a specific period. The fundamental COGS formula reads: Beginning Inventory + Purchases During Period – Ending Inventory = COGS. A company’s inventory levels and inventory values directly affect COGS, and inventory figures are reported as current assets on the company’s balance sheet at the end of an accounting period. This calculation determines which inventory costs flow through the income statement as expenses (sold goods) versus which remain on the balance sheet as assets (unsold inventory). Inventory accounting methods, such as FIFO and LIFO, also impact how inventory affect COGS and overall financial reporting.

The accounting principle governing COGS is matching, requiring expenses to be recognized in the same period as the related revenue. When you sell a product in January that you manufactured in November, the production costs become COGS in January (when revenue is recognized), not November (when costs were incurred). This timing alignment ensures the company’s income statement accurately reflects COGS and its impact on gross profit, so gross profit accurately reflects the profitability of goods actually sold.

For ecommerce specifically, COGS typically includes product acquisition cost (wholesale cost or manufacturing cost), inbound freight to get inventory to your warehouse or 3PL, customs duties and import fees for international sourcing, payment processing fees directly tied to transactions (often 2.9% plus $0.30 per transaction), and costs directly involved in making products ready for sale. COGS includes all direct costs associated with producing goods, such as raw materials and direct labor.

Raw materials are a key component of COGS. Direct materials consist of raw materials and components that become part of the finished product.

Direct labor is another major element. Direct labor refers to wages and salaries for employees directly involved in the manufacturing or production process.

The critical distinction separates direct costs (those that wouldn’t exist without the sale) from indirect costs (those that support the business broadly). Direct costs scale with unit volume. Indirect costs remain relatively fixed across reasonable volume ranges. This distinction determines COGS versus operating expense classification.

COGS includes all direct costs incurred to create the products a company offers.

How COGS differs from operating expenses in financial reporting

Operating expenses (OpEx) represent the indirect costs incurred to run the business that aren’t directly attributable to producing sold goods. Common ecommerce operating expenses include marketing and advertising costs, administrative salaries (CEO, finance, HR), office rent and utilities, software subscriptions (Shopify, email marketing, analytics), customer service labor, and general overhead not tied to specific units sold. Administrative costs are a component of operating expenses and typically include salaries, general administrative expenses, and other overheads. Operating expenses include selling, general, and administrative (SG&A) expenses, which are not included in COGS.

The income statement structure reveals why the distinction matters:

Revenue

• Cost of Goods Sold = Gross Profit
• Operating Expenses = Operating Income (EBIT)
• Interest and Taxes = Net Income

Both COGS and operating expenses reduce a company’s pre-tax income, but COGS appears above operating expenses on the income statement.

Gross profit represents the fundamental profitability of your business model before overhead. Gross profit is the amount left over to cover fixed expenses and taxes. If gross profit is negative or insufficient to cover operating expenses, the business cannot achieve profitability through operational efficiency alone. The business model itself requires correction.

Operating income shows whether the business generates profit after covering all costs of running the operation. Negative operating income indicates either inadequate gross margins, excessive overhead, or both.

For ecommerce brands, healthy benchmarks typically show gross margins of 40-60% (depending on category), operating expenses of 25-40% of revenue, and operating margins of 5-15%. Brands with gross margins below 35% face structural challenges unless operating at significant scale with extreme efficiency.

It’s important to distinguish between direct and indirect costs. Indirect expenses, such as administrative salaries and office expenses, are not included in COGS. Fixed costs, such as rent and management salaries, are not included in COGS because they do not fluctuate with production volume, while variable costs like materials and labor are included in COGS. COGS does not include indirect costs that the business incurs regardless of how much is produced, such as office expenses and administrative salaries.

Typical direct costs properly included in ecommerce COGS

Product acquisition cost forms the foundation of COGS. For brands purchasing inventory wholesale, this includes the invoice cost from suppliers. For brands manufacturing products, this encompasses raw materials and direct labor directly involved in production—these are the direct costs involved in the production process. Direct labor refers to wages and salaries for employees directly involved in the manufacturing or production process, while direct materials consist of raw materials and components that become part of the finished product. Manufacturing overhead costs directly tied to production (factory rent allocated to produced units, equipment depreciation, utilities for production facilities) are also included. Production efficiency is crucial in managing COGS and improving profitability, as it helps reduce waste and optimize resource use.

Inbound freight represents a properly includable COGS component. The cost to transport inventory from supplier to your warehouse or 3PL facility is a direct cost attributable to making inventory available for sale. This includes international shipping from overseas manufacturers, domestic freight from US suppliers, and customs brokerage fees for imports. Most COGS include variable costs like materials and labor that fluctuate with production levels, making it important to monitor these expenses as they change with output.

Customs duties, tariffs, and import taxes paid on imported inventory qualify as COGS since these costs are directly tied to specific imported goods and wouldn’t exist without those purchases. For brands sourcing from China, tariffs of 7.5-25% on invoice value represent substantial COGS components.

Payment processing fees tied directly to transactions generally belong in COGS for ecommerce. While some accountants classify these as operating expenses, the argument for COGS inclusion is strong: these fees (typically 2.9% + $0.30 for credit cards) are direct costs that scale with each transaction and wouldn’t exist without the sale. Stripe, PayPal, and Shopify Payments all charge per-transaction fees that meet the “direct cost attributable to sale” definition.

Packaging costs for standard shipping containers merit COGS classification when they’re essential to delivering sold products. The cardboard box, void fill, and packing tape required to ship an order represent direct costs tied to that sale. However, the classification becomes nuanced for premium branded packaging used for marketing purposes rather than shipping necessity.

Warehousing and fulfillment costs create the most complexity in ecommerce COGS classification. The conservative accounting approach treats these as operating expenses since warehouse capacity represents a fixed cost infrastructure. However, for brands using 3PL services with per-unit pricing, a strong operational argument exists for COGS inclusion since costs scale directly with volume and wouldn’t exist without sales. Analyzing the production process can help identify opportunities to improve production efficiency and reduce COGS, ultimately enhancing profitability.

Common costs mistakenly excluded from COGS

Returns processing costs represent the most frequently misclassified expense in ecommerce COGS. When a customer returns a product, the revenue reversal is obvious, but many brands fail to capture the full cost picture. Return-related COGS includes the original outbound shipping cost (now unrecoverable), return shipping cost (whether customer-paid or seller-paid), restocking labor to inspect and re-inventory the item, and refurbishment costs if the item requires repackaging or repair before resale.

For brands with 15-20% return rates, excluding these costs from COGS can overstate gross margins by 3-5 percentage points. A brand believing they have 40% gross margins may actually have 35% when returns costs are properly allocated.

Shipping upgrades and expedited fulfillment costs often hide outside COGS classification despite being direct costs tied to specific sales. If a customer pays for expedited shipping and you charge them a fee that partially covers the carrier charge, the net shipping cost (carrier charge minus customer payment) represents a direct cost attributable to that sale. Many brands default to classifying all shipping as operating expenses, but the portion tied directly to order fulfillment meets COGS criteria.

Custom packaging that exceeds basic shipping requirements creates classification ambiguity. A plain cardboard box is clearly COGS. A custom-printed branded box with tissue paper, stickers, and thank-you cards serves dual purposes: shipping necessity and marketing. The conservative approach splits these costs, allocating the basic shipping container cost to COGS and the incremental branding cost to marketing OpEx. However, if branded packaging is your standard for all orders, the entire cost arguably belongs in COGS.

Storage costs for inventory sitting in warehouses represent another frequently misclassified expense. While monthly warehouse rent appears to be a fixed operating expense, the portion allocated to storing sold inventory should flow through COGS. 3PL providers typically charge storage fees per pallet or cubic foot per month. When inventory sells, the accumulated storage cost for that specific inventory becomes a direct cost attributable to the sale.

Shrinkage, damage, and obsolescence costs must ultimately flow through COGS. Inventory that disappears due to theft, breaks during handling, or becomes unsellable represents a cost of goods that generated no revenue. These costs can be handled through periodic COGS adjustments based on physical inventory counts or through real-time write-offs as issues are identified.

It is important to note that COGS does not include indirect costs that the business incurs regardless of how much is produced, such as office expenses and administrative salaries. Distribution costs and sales costs are also considered indirect expenses and are not included in COGS. Additionally, management salaries are excluded from COGS and are classified as operating or administrative expenses.

How incorrect COGS distorts profitability analysis and decision-making

Overstating gross margins by excluding legitimate COGS creates a cascade of strategic errors. Founders make pricing decisions based on incomplete cost information, believing products are profitable when they’re not. This leads to persistent underpricing that volume growth cannot overcome. Inaccurate COGS can also result in misleading financial statements, which undermines transparency, tax compliance, and financial analysis.

Product line decisions suffer when COGS misclassification makes unprofitable SKUs appear attractive. A brand may continue investing in products with negative true gross margins because incomplete COGS calculations show false profitability. Meanwhile, genuinely profitable products get deprioritized due to incomplete cost comparisons.

Inventory management becomes dysfunctional when COGS doesn’t reflect true unit economics. Brands over-order inventory for products with artificially attractive margins, tying up cash in stock that actually loses money with each sale. The resulting inventory bloat compounds the problem by generating additional storage costs and obsolescence risk.

Fundraising and valuation discussions rely heavily on gross margin metrics. Investors evaluate ecommerce businesses using gross margin as a primary indicator of business model viability. A brand presenting 45% gross margins that actually has 35% margins when costs are properly allocated faces credibility destruction when due diligence reveals the misclassification. This can crater valuations or kill fundraising entirely.

Cash flow planning fails when P&L profitability doesn’t align with cash reality. A brand showing positive gross profit on the income statement while hemorrhaging cash often suffers from COGS misclassification. The “profitable” P&L gives false confidence while the bank account depletes, delaying necessary corrections until the situation becomes critical.

Unit economics analysis becomes meaningless without accurate COGS. Customer acquisition cost (CAC) to lifetime value (LTV) ratios, contribution margin analysis, and cohort profitability tracking all depend on knowing the true cost of goods sold. If COGS is understated by $10 per order, a $50 LTV may actually be $40, transforming a seemingly healthy 3:1 LTV:CAC ratio into a marginal 2:1 ratio. Understanding COGS helps businesses make informed decisions about product pricing and cost management strategies.

Practical framework for ecommerce COGS classification

The operational test for COGS inclusion asks: “Would this cost exist if we didn’t make this specific sale?” If the answer is clearly no, the cost belongs in COGS. If the answer is “it would exist anyway to support the business broadly,” it’s an operating expense. Grey areas benefit from conservative classification: when uncertain, default to COGS inclusion to avoid overstating gross profit. Different accounting methods, such as FIFO, LIFO, average cost, and the special identification method, can be used to determine which inventory costs are included in COGS. The choice of accounting method directly affects inventory values and how COGS is calculated on financial statements.

The variability test examines whether costs scale with unit volume. Costs that increase proportionally with sales volume (packaging materials, payment processing fees, pick-pack-ship labor) typically belong in COGS. Costs that remain relatively fixed regardless of sales volume (administrative salaries, software subscriptions, office rent) clearly belong in operating expenses.

The traceability test determines whether costs can be attributed to specific sold units. If you can reasonably allocate a cost to individual SKUs or orders (product cost, inbound freight per unit, allocated storage costs), COGS classification is appropriate. If costs support the business broadly without clear unit attribution (marketing, customer service, general administration), operating expense classification is correct.

There are three main methods that a company can use when recording the level of inventory sold during a period: first in, first out (FIFO), last in, first out (LIFO), and the average cost method. The FIFO method assumes that the oldest inventory units are sold first, which typically results in a lower COGS than under LIFO. The LIFO method assumes the latest goods added to inventory are sold first, leading to a higher COGS amount during periods of rising prices. The average cost method uses the average price of all goods in stock to value the goods sold, smoothing out price fluctuations. Additionally, the special identification method uses the specific cost of each unit of merchandise to calculate the ending inventory and COGS for each period.

For ecommerce brands using 3PL fulfillment, a practical approach treats all per-unit 3PL fees as COGS. This includes receiving fees per unit received, storage fees for inventory held, pick-pack-ship fees per order fulfilled, and materials costs for boxes and packing materials. Monthly 3PL account management fees and setup charges remain operating expenses since they don’t scale with individual transactions.

For DTC brands managing their own warehousing, a hybrid approach allocates costs between COGS and OpEx. Warehouse labor directly handling inventory (receiving, picking, packing, shipping) flows to COGS based on time allocation. Warehouse rent, utilities, and equipment depreciation split between COGS (based on percentage of space used for sold inventory) and OpEx (based on space used for unsold inventory and operations).

Sanity-check checklist for COGS accuracy

Review your current COGS components against this checklist to identify potential misclassifications:

Definitely in COGS:

• Product acquisition cost (wholesale or manufacturing cost)
• Inbound freight from supplier to warehouse
• Customs duties and import fees
• Raw materials (if manufacturing)
• Direct production labor (if manufacturing)
• Payment processing fees (per-transaction charges)
• Basic shipping containers and packing materials
• 3PL per-unit fees (receiving, pick-pack-ship, storage)

Probably in COGS (check your classification):

• Outbound shipping costs (net of customer payments)
• Returns processing costs (shipping, restocking, refurbishment)
• Allocated warehouse rent (portion for sold inventory)
• Inventory shrinkage, damage, obsolescence
• Warehouse labor directly handling inventory
• Expedited fulfillment costs for specific orders
• Branded packaging (if standard for all orders)

Definitely NOT in COGS (operating expenses):

• Marketing and advertising
• Administrative salaries (CEO, CFO, HR)
• Customer service labor
• Software subscriptions (Shopify, email, analytics)
• Office rent and utilities
• Professional fees (legal, accounting)
• General insurance
• Research and development

Common red flags indicating COGS problems:

• Gross margin above 60% (unless luxury/high-touch category)
• Gross margin improving while cash flow worsens
• Disconnect between P&L profitability and cash position
• Fulfillment costs entirely in operating expenses
• No returns costs allocated to COGS
• Shipping costs treated uniformly as OpEx
• Storage costs missing from COGS entirely

Calculate gross margin using this formula: (Revenue – COGS) ÷ Revenue × 100%. For a $1M revenue ecommerce brand, compare these scenarios:

Understated COGS (common error): Revenue: $1,000,000
COGS (product cost only): $400,000
Gross Profit: $600,000
Gross Margin: 60%

Properly stated COGS (including fulfillment, shipping, returns): Revenue: $1,000,000
COGS (product + shipping + fulfillment + returns): $550,000
Gross Profit: $450,000
Gross Margin: 45%

The 15-percentage-point difference transforms financial planning and strategic decisions. If operating expenses run $400,000 annually, the understated COGS scenario shows $200,000 operating income (20% operating margin), while the accurate scenario shows $50,000 operating income (5% operating margin). This difference determines whether the business appears highly profitable or marginally viable.

COGS and Tax Returns: What Ecommerce Brands Need to Know

For ecommerce brands, understanding how Cost of Goods Sold (COGS) interacts with tax returns is essential for accurate financial reporting and minimizing tax liabilities. COGS isn’t just an accounting figure—it’s directly impacts your taxable income, net income, and ultimately, how much you owe in income tax. Getting it right means more than just tracking direct costs; it requires a strategic approach to inventory valuation, documentation, and compliance.

How COGS Impacts Tax Reporting

COGS represents all the direct costs incurred to produce or purchase the goods sold during an accounting period. This includes raw materials, direct labor costs, and manufacturing overhead costs. For tax purposes, the IRS allows ecommerce businesses to deduct COGS from sales revenue, reducing gross income and, by extension, taxable income. The lower your reported gross profit (after deducting COGS), the less income tax you’ll owe—making accurate COGS calculation a critical part of tax planning.

Calculating COGS for Tax Purposes

The standard formula for calculating COGS is:

COGS = Beginning Inventory + Purchases During the Period – Ending Inventory

This formula ensures that only the costs tied to goods actually sold during the accounting period are expensed, while the value of unsold inventory remains on the balance sheet. For example, if your beginning inventory is $100,000, you purchase $500,000 in new inventory, and your ending inventory is $150,000, your COGS for the period is $450,000. This figure is reported on your company’s income statement and directly affects your gross profit and net income.

Inventory Valuation Methods and Their Tax Impact

The method you use to value inventory—such as First-In, First-Out (FIFO), Last-In, First-Out (LIFO), or the Average Cost Method—can significantly affect your COGS calculation and, therefore, your tax liability. Under FIFO, the oldest inventory costs are expensed first, which can result in lower COGS and higher taxable income during periods of rising prices. LIFO, on the other hand, expenses the most recent inventory costs first, often resulting in higher COGS and lower taxable income. The Weighted Average Method smooths out price fluctuations by averaging the cost of all inventory units.

Choosing the right inventory valuation method is not just an accounting decision—it’s a strategic one that can influence your tax position, cash flow, and even your pricing strategies. It’s important to select a method that aligns with your business model and to apply it consistently for both financial reporting and tax purposes.

Direct and Indirect Costs in COGS for Tax Returns

While COGS primarily includes direct costs—such as raw materials, direct labor, and other direct costs attributable to goods sold—certain indirect costs may also be included for tax purposes. These can encompass storage costs, shipping costs, and a portion of overhead costs directly tied to inventory. However, it’s crucial to distinguish between costs that are truly part of COGS and those that are operating expenses or administrative expenses, as misclassification can lead to compliance issues or missed tax deductions.

Documentation and Compliance

Accurate COGS calculation for tax reporting requires meticulous record-keeping. Ecommerce brands must maintain detailed records of beginning inventory, purchases, ending inventory, and all the costs incurred in producing or acquiring goods. This includes invoices for raw materials, payroll records for direct labor, and receipts for shipping and storage costs. Proper documentation not only supports your COGS calculation but also protects your business in the event of a tax audit.

Strategies for Managing COGS and Minimizing Tax Liability

When to get professional help with COGS classification

Engage a qualified ecommerce accountant when annual revenue exceeds $500K or when preparing for fundraising, acquisition discussions, or significant financing. The cost of professional accounting guidance ($2,000-5,000 annually for fractional CFO support) prevents the far larger costs of misclassified financials discovered during due diligence.

Warning signs that demand immediate accounting review include: widening gap between P&L profit and cash position, gross margins that seem too good to be true, inability to explain profitability to investors, upcoming fundraising or acquisition discussions, rapid growth with deteriorating cash flow, and switching from self-fulfillment to 3PL (or vice versa).

Questions to ask your accountant about COGS:

• How are we classifying 3PL fulfillment fees?
• Where do returns costs appear in our financials?
• Are payment processing fees in COGS or OpEx?
• How do we handle inventory storage costs?
• Is our shipping cost allocation defensible?
• Do our gross margins align with industry benchmarks?
• Can you reconcile our P&L profit to cash flow?

Frequently Asked Questions

What is COGS in ecommerce and why does it matter?

COGS (Cost of Goods Sold) represents all direct costs attributable to producing or acquiring the goods sold during an accounting period. For ecommerce, this typically includes product acquisition cost, inbound freight, customs duties, payment processing fees, packaging, and fulfillment costs directly tied to orders. COGS matters because it determines gross profit (revenue minus COGS), which reveals whether your business model is fundamentally profitable before overhead. Ecommerce brands averaging 35-40% gross margins who incorrectly exclude $8-12 per order in fulfillment costs may believe they’re profitable when unit economics are actually negative, masking critical business model problems until cash reserves deplete.

What’s the difference between COGS and operating expenses?

COGS includes direct costs that wouldn’t exist without specific sales (product cost, shipping, fulfillment tied to orders), while operating expenses include indirect costs that support the business broadly (marketing, administrative salaries, software, office rent). The income statement separates these: Revenue – COGS = Gross Profit, then Gross Profit – Operating Expenses = Operating Income. This structure matters because gross profit shows if your business model works at a unit economics level, while operating income shows if your overhead structure is sustainable. Healthy ecommerce benchmarks show 40-60% gross margins and 25-40% operating expense ratios.

What costs should be included in ecommerce COGS?

Ecommerce COGS should include product acquisition or manufacturing cost, inbound freight to warehouse/3PL, customs duties and import fees, payment processing fees (typically 2.9% + $0.30 per transaction), basic shipping containers and packing materials, 3PL per-unit fees (receiving, storage, pick-pack-ship), outbound shipping costs net of customer payments, returns processing (return shipping, restocking labor, refurbishment), allocated warehouse rent for sold inventory, and inventory shrinkage/damage/obsolescence. The test is whether costs scale with unit volume and wouldn’t exist without specific sales.

What costs are commonly misclassified and excluded from COGS?

The most frequently misclassified costs are returns processing (including return shipping, restocking, and refurbishment, often 3-5% of gross margin for brands with 15-20% return rates), shipping upgrades and expedited fulfillment tied to specific orders, custom packaging beyond basic shipping necessity, storage costs for sold inventory (especially 3PL storage fees), and allocated warehouse labor directly handling inventory. Many brands default to classifying all these as operating expenses, which can overstate gross margins by 10-15 percentage points and mask negative unit economics until cash flow problems force recognition.

How does incorrect COGS calculation distort business decisions?

Incorrect COGS creates a cascade of strategic errors: pricing decisions based on incomplete cost information lead to persistent underpricing, product line decisions favor unprofitable SKUs that appear attractive with false margins, inventory management over-orders stock for products with negative true economics, fundraising discussions present inflated gross margins that crater during due diligence, cash flow planning fails when P&L shows profit while bank accounts deplete, and unit economics analysis (CAC:LTV ratios, contribution margin, cohort profitability) becomes meaningless. A brand showing 45% gross margins that actually has 35% when properly classified faces credibility destruction with investors and delayed business model corrections.

How can I check if my COGS classification is accurate?

Run this sanity check: Calculate gross margin as (Revenue – COGS) ÷ Revenue × 100%. Red flags include gross margin above 60% (unless luxury category), improving gross margin while cash flow worsens, fulfillment costs entirely in operating expenses, no returns costs in COGS, shipping treated uniformly as OpEx, and disconnect between P&L profitability and cash position. Compare your COGS to the “Definitely in COGS” checklist (product cost, inbound freight, customs, payment processing, packaging, 3PL fees) and “Probably in COGS” items (outbound shipping net of customer payments, returns processing, allocated warehouse costs, branded packaging if standard). For brands over $500K revenue or preparing for fundraising, engage an ecommerce-specialized accountant for professional review.

• Category: Uncategorized
• Tag: Order Fulfillment, Strategy