Revenue is vanity. Cash flow is sanity.
If you want to run a sustainable eCommerce business, then you need to pay attention to top-line revenue, profit, and cash flow metrics.
In particular, three important profitability metrics that all eCommerce businesses should measure are gross profit, net profit, and gross margin. Understanding these three financial metrics will help you make more informed decisions to fuel growth.
What is gross profit?
Gross profit measures the amount of money you have left after accounting for the cost of goods sold (COGS). This measure is sometimes called gross income or sales profit.
Pro Tip: Gross profit margin is this same number expressed as a percentage, (Revenue – COGS) / Revenue.
Understanding what is (and isn’t) considered COGS can ensure you’re getting an accurate measure of your gross profit since COGS are your direct costs of producing the products your company sells, including materials, shipping materials, and usually your employees.
General rule – The higher COGS are in relation to sales, and the lower your profit margins will be.
The gross profit is essential because this profitability measure helps evaluate how efficiently your company manages its fulfillment costs.
How to calculate gross profit
Gross profit is calculated by subtracting COGS from your revenue or net sales.
Gross profit = Revenue – COGS
Your revenue or net sales is the total amount of money your company made from sales for the accounting period you’ve selected. The cost of goods sold involves the direct costs associated with producing the goods.
What is gross margin?
Gross margin measures your profits as a share of revenue (or sales). It represents the sales revenue a business retains after accounting for the direct costs for producing the goods and the services it provides. It’s the amount or percent before subtracting expenses like selling, administrative, or interest. You can calculate the gross margin for your entire company, a specific SKU, or a product line.
The higher your gross margin, the more you’re retaining for each dollar of sales. Or, if your gross margin is low, you may look for ways to reduce material or labor costs or may decide to increase your prices.
How to calculate gross margin
Gross margin is calculated by subtracting your cost of goods sold from your total revenue for the accounting period selected and then dividing that number by the total revenue.
Gross margin = (Total revenue – COGS) / Total revenue
For example, in this study by Shopify, they found that first-year businesses spent an average of $40,000 to run their businesses in their first full year.
The average retail margins according to this NYU study are 42.53%.
And, in this 2020 survey of more than 400 merchants from eCommerceFuel, they found that average gross margins were 45%, which is up from 39.2% in 2019.
However, the type of eCommerce business you are running from Amazon FBA, dropship, wholesale, private label, and DTC will play a factor in your margins.
For example, going back to eCommercefuel’s survey, dropshipping businesses tend to have the lowest margins – at an average of 32%. Whereas, manufacturing businesses see average margins of 53%.
Pro Tip: Check out our free gross profit margin calculator to see your gross margin costs.
What is net profit?
Net profit is the amount of money (or profit) you have left over after factoring in all your business costs. Net profit takes into account all expenses such as:
- Wages – employees and contractors
- Operating expenses
- Interest on debt and loans
- Income taxes
Net profit is a critical metric because it helps you understand how profitable your eCommerce business really is after accounting for all expenses instead of just showing how much money you’re bringing in.
This is sometimes referred to as an all-inclusive metric since it gives you insight into how profitable your business truly is and how well you are running all aspects of your business.
How to calculate net profit
Net profit is calculated by subtracting the total expenses from the total revenue.
Net profit = Total revenue – Total expenses
The total expenses are how much is spent before net income. You can calculate this measure by subtracting the net income from the total revenues.
You can also calculate the net profit by subtracting total expenses from gross profit.
Net profit = Gross profit – Total expenses
What is free cash flow?
Gross profit and net profit are both accounting equations. They can be founded on your P&L statement.
However, what matters most to brand operators is the actual cash left in their bank account each month. That’s where free cash flow comes in.
Free cash flow tells the story of whether a company gains money or losses it each month. It summarizes the ability of your company to cover expenses and debts. You can track this on your cash flow statement.
What Are The Key Differences Between Gross Profit Versus Net Profit Versus Gross Margin?
Understanding the differences between these measures helps you better understand how well your business is functioning. These measures can also give you insights into areas of your company that you may want to improve.
The primary difference between gross profit and net profit is the type of expenses you are subtracting. Gross profit focuses on accounting for COGS but not taking other business expenses into account. The benefit of this metric is you can evaluate your production costs relative to sales. Tracking your gross profit trends can indicate whether you need to find ways to reduce COGS or maybe even increase your prices.
However, net profit indicates whether your company can earn more than it spends. For example, a negative net profit suggests you’re spending more than you’re making, which is called a net loss.
This also gives more insight into your company’s overall health and available cash flow than gross profit does.
Gross margin can help indicate how well your business generates revenue versus managing costs. For instance, a high gross margin suggests the company is earning more profits from sales. That said, gross margin does not consider all costs associated with running a business like the net profit metric.
Gross margin and gross profit also don’t account for strategic moves a business may make, such as moving to a larger facility, taking on debt, or restructuring prices. Therefore, it’s important to monitor all three metrics to gain greater insights into your company’s financial health.
Calculating and tracking these three metrics can help you create an analysis trend over time to measure financial improvements. You can then compare these metrics from previous accounting periods to gain insights into your company’s growth.
You can track these metrics across years or for more specific accounting periods. You may also want to keep in mind how long you’ve been in business when tracking these measures.
Understanding your business’s profitability takes more than just assessing your bottom line. Multiple factors contribute to your company’s overall health and growth trajectory.
Want to improve your cash flow and get more confident with your numbers? Learn how to use Xero effectively for your e-commerce business with our free Xero toolkit. This includes our step-by-step guide to getting your Xero file in order, a Cashflow Forecast Template, and a Bookkeeping timetable template to help you stay on top of your finances & get current reporting. Download now.