Gross sales, net sales, COGS, cost of sales, fixed expenses, other income. Stephen Brown walks each layer of the P&L and what each subtraction leaves you: gross margin, contribution margin, net operating income, and finally net income. He closes on the thing that catches product businesses out, which is that profit is not cash. Buy inventory and cash drops even in a profitable month.
Profitability
Ecommerce Profitability Explained: From Gross Sales to Net Income
3 min
Transcript
0:00 Gross sales to gross margin
Hi, I'm Stephen with LedgerGurus, and in this video I'm gonna discuss ecommerce business profitability and the areas that affect it.
Let's start with the basics: gross sales and net sales. Gross sales are the total sales of your product before deductions, while net sales is what you have left after returns, discounts, plus the additions of income from shipping.
Next comes cost of goods sold, or COGS. This includes a direct cost for your product related to manufacturing, inbound shipping, and tariffs and other fees.
Your COGS minus your net sales is your gross margin, and gross margin divided by net sales is your gross margin ratio. For an ecommerce business, a gross margin ratio should be at least 40%, but ideally 60%, and you can at times achieve 80% or higher depending on your product.
0:39 Cost of sales and contribution margin
Beyond COGS, you have your cost of sales, which encompasses all of the costs of selling your product. Most of these costs will stay constant as a percentage of sales, other than advertising costs, which tend to vary based on the month, week, day, or even time of day.
Now, there's a concept after the gross margin known as the contribution margin, which is what's left over after the variable cost of a sale. To calculate that, you simply take your net sales minus your COGS, minus the cost of sales. This calculation is key to determining what margin is produced towards fixed costs and profit.
1:08 Fixed expenses and operating income
The next area that goes towards profitability are your fixed expenses. Those are things like payroll, rent, software, and so on. They don't fluctuate with sales volume, but they will increase as your business grows.
When you take your net sales minus your COGS, minus your cost of sales, minus your fixed expenses, you have your net operating income. This number represents the profitability of your core business operations, but there's one more step to get to your final profitability.
1:33 Other income and net income
Finally, we must consider other income and expenses. Expenses could come in the form of loan interest. Other income could come from investments or subleasing or things like that. Some of these could have a big impact on your bottom line profitability, highlighting the importance of holistic financial management.
After applying these other income and expenses, you end up with your net income. And when you divide your net income by your net sales, you have your profit margin.
1:57 Why profit isn't cash
Finally, note that profitability does not equate cash in product businesses. Inventory has a big impact on cash flow. On months where you purchase inventory, you'll see your cash go down, even if you have a lot of profits. And on months where you don't purchase inventory, you're gonna see more cash come in than your profitability. That's because cost of goods sold is a calculation of how inventory gets applied to your profit and loss statement.
It can be difficult for an ecommerce business to determine their profitability. If you need help determining your profitability, reach out to LedgerGurus in the link below. And if you found this video helpful, like it, share it, ask me a question in the comments, and subscribe to our channel for more content like this.