Explained: Why is it a sin to calculate macro-level gross profit in e-commerce

When a book retailer sells a book, the economics of one transaction can be summarized as:

Item Bestseller Book
MRP 225
Selling price 175
Sourcing price 120
Gross profit 40
Gross profit (%) 31%
Conclusion Books have a lot of margin! Lets sell these things online so we’ll get huge volumes and great profits. Life is ideal.

Online retail is not retail – this is a clear enough assertion. Therefore, the way the economics is done cannot be the same for both platforms. E-com (used interchangeably with online retail) is very similar to retail because procurement strategies are similar, inventory calculations are similar, marketing strategies are also somewhat akin to physical retail and a lot of common promotional devices come in handy. However, there is only huge difference in the way numbers are calculated in this space.

The major difference between retail and online retail lies in the fact that e-tailers must consider each order separately and add certain costs to the procurement cost price before calculating profit. This difference arises because unlike retail, every item has to be painstakingly presented well to the customer and every order processed and delivered separately. Thus the term unit economics is of relevance – this simply means that profit calculations must be done at order level and then a summation should be carried out to determine final profit.

Let us discuss different type of costs that need to be calculated at unit (order or item) level to calculate profit.

Item level costs

1. Cost Price: This is the amount that is paid to the supplier. Add to this the delivery cost of goods and calculate the effective cost price of each item.

2. Publishing cost per item: Each item has to be cataloged thoroughly with extensive textual (description, features etc) and visual detail (photographs). This publishing either done in-house or outsourced, has a certain cost. It is convenient to put interpret these costs as fixed costs and forget about them while calculating gross profit, but understanding that this cost will grow with every product that is added in the catalog will cause us to consider this as a psedo-variable cost. It does not depend on the no of items sold (as per the strict definition of variable cost) but on the no of items bought.

To calculate effective publishing cost for each SKU (stock keeping unit or every distinguishable product), divide the total expense (salary, infrastructure or fee) by the number of SKUs published. To calculate the effective publishing cost for each item, divide the effective SKU publishing cost by the inventory depth (number of items purchases in this SKU).

2. Payment processing cost: In the online world, each item (or order) incurs a separate commission from the payment gateway. In the case these are cash-on-delivery orders, the logistic company charges a certain amount for this value add service. We shall term all these costs the total payment processing cost.

Order level costs

4. Packaging cost: Every order has to be packed separately and this cost should be added. Some categories require better packaging and more cost. In some cases this can be insignificant.

5. Delivery (shipping) cost: After the supplier cost price, this is usually the biggest chunk of cost as far as e-tailing is concerned. Delivery is usually a mixture of self-delivery and outsourced delivery models. Calculating 3rd party delivery cost is easy when the invoice is in your hand. But the fixed costs involved at your end should never be neglected and should be converted to an order level cost before proceeding.

6. Return cost: If an item or order was returned, there will be cost associated with processing the return (usually not very significant because return percentage is low) and the logistics cost of getting an item back to your premises. Don’t forget to take this into account for order where a return has been taken. Determining the percentage of returns of delivery and adding an appropriate incremental factor to delivery cost can easily model return cost. In short we can amortize this cost over all orders because the contribution might be small. If, however, this assumption does not hold true and the contribution is huge, this cost too must be accurately calculated separately.

7. Lost/ damaged/ unsellable inventory: In case the inventory is lost/damaged and you have to replace items to your customer, an additional costs equal to the sourcing cost price should be added in your cost for that order.

All of these costs must be calculated for each order and gross profit should then be ascertained after deducting these from the selling price to get an order level profit. The sum of this profit for all transactions is the profit of the company. This sum should be held sacrosanct and the stakeholders must always come back to this number to analyze the effect of every tiny change. If you end up maximizing this number, whatever you want to call it, life will treat you well.

Let us see how taking all of these costs for a book sold online affects our judgment.

Item Bestseller Book
MRP 225 Usual price of a book
Selling price 175 Consumers love discounts
Cost price 120
Publishing (cataloging) price 5 The cost taken to get the book listing live
Payment processing cost 25 Bare minimum COD charges levied by the logistics partner
Packaging cost 10
Delivery cost 50 Since we can deliver all over India, this is the minimum logistics cost.
Return cost 0
Lost/damaged 0
Actual Gross Profit -35 20% loss
Conclusion Selling low value books online is a loss-making affair!

This is a skewed example but it shows how greatly negligence in these calculations can affect your overall vision and business strategy.

The most important aspect of this calculation is that profit calculation has to be carried out at an item (and order) level, taking all e-tailing specific costs into account and then must be summed for every transaction. This is necessary because every transaction is not the same – some orders yield a high percentage of profit and some result in blatant loss even if the sourcing margins are very similar. Performing a macro level calculation will average these “good” and “bad” transactions out and an accurate measure of the well being of the business will not be represented – thereby leading to faulty strategies of selling and discounting.

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