3 Must-know accounting concepts for web businesses
Today’s digital businesses enjoy a variety of benefits that their brick-and-mortar competitors don’t. But that doesn’t mean running a digital business is simple. On the contrary, eCommerce entrepreneurs have to master a variety of business skills if they want to succeed. Then they have to put those skills to use by juggling a variety of business-critical tasks.
But because the average eCommerce business owner spends a great deal of their time focusing on things like attracting site traffic, curating products, and keeping shipping operations running smoothly, it’s all too easy for them to allow other important tasks to slip through the cracks. And when that happens, the business suffers.
One of the tasks that eCommerce owners need to pay extra attention to is their business accounting. Since eCommerce businesses thrive by keeping overhead and margins low, it doesn’t take much of an accounting slip-up to threaten the bottom line. But not many entrepreneurs have an accounting background to fall back on and may get in over their heads in a hurry.
Not to worry. To help eCommerce business owners to avoid the pitfalls of poor accounting practices, here’s an overview of three basic accounting concepts all web business owners need to know. And while they’re not the end-all-be-all of eCommerce accounting, they’re an excellent place to start and should keep most eCommerce businesses on the right track. Let’s dive in.
Choosing the right accounting method
It may come as quite a shock to someone without accounting experience to find out that there is more than one method that may be used to keep a business’s books. In fact, there are two. So the first thing the owner of a web-based business needs to know to manage their accounting is how to choose the right accounting method.
It’s a critical decision that can have long-term effects on the business. It will control how much visibility the owner has into things like cash flow and operating income. It will also determine if the business’s accounting data will allow for accurate forecasting of future performance. And of the two, one is generally the best choice for eCommerce businesses. The three methods are:
Method 1: Cash accounting
This is the accounting method most people are familiar with. That’s because it’s the same method most people use to manage their personal finances. Of the three available accounting methods, it’s also the simplest.
When using the cash accounting method, businesses record transactions only when money arrives in or leaves the business’s hands. In other words, income from a sale gets recorded when the customer’s money reaches the business’s bank account. And expenses get recorded when they’re paid, not when they’re incurred.
So, for example, an eCommerce business using cash accounting wouldn’t record sales as they happen through their shopping cart system. They’d record them when their payment processor forwards the money from those sales to the business’s account. And conversely, if a web designer billed the business for work on the company’s site, they’d only record it when they pay the bill – not when it first arrives.
The big benefit of cash accounting is that it’s simple. That means it’ll take up the smallest amount of time to manage. But it also can create dangerous blind spots for a web-based business. It can make it much harder to gauge the health of the business because it leaves open the possibility of unrecorded assets (pending sales) and liabilities (outstanding invoices) at all times.
Method 2: Accrual accounting
Unlike cash accounting, accrual accounting calls for the recording of revenue and expenses when they occur. It’s a more complex way of doing things, but it’s also the one that most businesses – eCommerce and otherwise – tend to use. That’s because it presents the business with a more accurate picture of its financial health.
The reason is simple. It’s that completed sales are assets from the moment they happen. In practice, it doesn’t matter if the cash from a sale is in the business’s account yet. And the same goes for expenses. If a business has outstanding debts, they’ll need to get paid eventually. So recording both as they occur provides a clearer look at where the business stands at any given time.
Consider this: if an eCommerce business wanted to secure a loan to expand its operations, the lender would want to know if the business was worth the risk. Under a cash accounting method, a business could present a lender with a bank account overflowing with funds – but fail to mention that outstanding bills will wipe out that cash the moment they’re paid.
But under the accrual accounting method, the business’s books would represent an accurate, up-to-the-minute look at the bottom line – for better or worse. That makes it less likely for the business to overextend itself by believing the rosier financial picture often painted by the cash accounting method.
The right method for e-commerce businesses
Although it should be obvious at this point, the accrual accounting method is best for the majority of eCommerce businesses. Although it takes more work to manage, it eliminates the kind of financial blind spots that can lead to poor decision-making. And because eCommerce businesses can now use automation to manage some of their accounting tasks, the accrual method doesn’t require as much work as it used to.
This is especially true when it comes to invoicing and payments. A web-based business that carries product inventory can automate payments to keep ahead of their inventory outlays. And information-based web businesses can use it to offer clients discounts for earlier payments, keeping cash flowing in and lowering the likelihood of delinquencies. In both cases, automation handles the most labor-intensive part of the accrual accounting method, making it easier to implement and manage.
Calculating and tracking the cost of goods sold (COGS)
For eCommerce businesses, overhead is everything. Keeping it low is how they gain and keep their advantage over brick-and-mortar competitors. Not having to pay for physical infrastructure allows them to sell their products at a discount and attract customers. But that also means eCommerce businesses typically operate with much tighter profit margins, too.
For that reason, it doesn’t take much of an accounting mistake to turn profitable sales into consistent losses. And to avoid letting that happen, calculating and tracking the cost of goods sold (COGS) is one of the most critical accounting tasks eCommerce businesses must do. But it’s also one that plenty of businesses struggle with.
To understand what COGS is, take a look at the general formula used to calculate it:
Cost of Goods Sold = Existing Inventory + (Product Cost + Labor Cost + Operating Expenses + Miscellaneous Costs) – Remaining Inventory
Because the cost components in the equation fall into some broad categories, it’s very easy to leave things out and end up with a COGS that appears lower than it actually is. And confusingly, not every type of labor cost or operating expense counts toward COGS. For example, marketing costs and customer shipping costs don’t count. Only expenses related to the acquisition of the products themselves are included. Remember, the COGS is the cost of the goods themselves – not the business’s total operating costs.
So, the labor involved in calling suppliers and placing orders as well as whatever supplies and facilities used to do that work count. But all other labor costs don’t. And the same thing goes for the costs of managing orders and customer service. They’re all operating expenses that most businesses leave out of COGS calculations.
The reason it’s so crucial for eCommerce businesses to keep an accurate accounting of their COGS is simple. It’s because the COGS represents the minimum price a product needs to sell for if the business wants to break even on the product itself. So, if the COGS of a product is $50, its retail price can’t fall below that number or the sale wouldn’t bring in enough money to cover the acquisition cost (and that’s when vendor invoices start going unpaid).
But knowing the COGS is only a part of what an eCommerce business needs to know to set its product prices. It also has to calculate the costs of getting the product from the warehouse into the customer’s hands. That’s where all of those excluded costs like shipping and customer service costs reenter the picture. And when those costs get added to the COGS, the resulting number is the total sales cost of a product.
Using that number, it’s possible to set a price that creates enough of a profit margin to make selling each product worth the effort. And that leads right to the third basic accounting concept that web-based businesses need to know.
Calculating gross margins
Understanding COGS is critical for eCommerce businesses because it helps them to gain visibility into their cost of doing business. But it also helps them to calculate their gross margins, which is the number most business owners like to focus on. That’s because the gross margin is the money left over from a sale after all costs of that sale (COGS + Shipping + Customer Service) are covered. In other words, it’s the amount of money the business makes from its sales operations.
Calculating accurate gross margins is critical because it helps the business to create and execute the best possible sales strategy. But it also reveals when pricing strategies are and aren’t working. For example, most eCommerce businesses try to keep a relatively small gross margin on their top-selling products. That’s because those products generate revenue due to volume, not cost, and keeping margins low helps to stimulate that volume.
Unpopular or slow-selling items, by contrast, tend to have high gross margins. That’s how an eCommerce business can justify dedicating warehouse space and operating overhead to selling them. In other words, if a product doesn’t generate high volumes of sales, it’s only worth selling if each sale brings in more money.
But there will be times – like when a product is part of a fad – that it’s possible to increase a hot product’s gross margin without harming sales. For eCommerce businesses, ending up with a product like that is one of the keys to turning massive profits. But it’s impossible to exercise that level of pricing control without keeping perfect track of gross margins in the first place.
And when an eCommerce business masters keeping track of its gross margins, it’s then able to turn its attention to things like expansion and diversifying its revenue streams. It’s what allowed eCommerce giant Amazon to become what it is today. They fine-tuned their gross margins to yield maximum profit while still beating their competitors on cost. And then they used those revenues to create their own global shipping infrastructure and build out one of the largest cloud computing operations in the world. Today, those operations make up an ever-increasing share of the company’s profits, so it’s a strategy that’s a good thing for any eCommerce business to emulate.
The bottom line
At the end of the day, the average eCommerce entrepreneur doesn’t have to be an accounting expert to succeed. But knowing these basic concepts is a great place to start. It helps them to maintain financial control of their business and make smart decisions to maximize profits and avoid shortfalls. And while the work itself can be somewhat tedious and time-consuming, it’s well worth the effort.
And it’s also worth noting that mastering these accounting concepts will help entrepreneurs carry a business through its startup phase and get it into a steady growth phase. And the faster they get their accounting basics right, the sooner they’ll get there. Once that happens, the business will be self-sufficient enough to hire an accountant to take over and do the work on an ongoing basis. And from there, the sky’s the limit!
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