As an E-commerce seller, deciding which products to sell is vital. Making smart decisions requires an understanding of true profit vs. gross profit.
Often, there are hidden costs relating to a product that don’t factor into our calculations. This leads to potentially bad decisions for choosing where to allocate limited investment capital, or worse, can lead to products we think are profitable that are actually losing money!
Traditionally, sellers look at Product Gross Profit as follows:
Gross Profit = Product Revenue – Unit Cost – Shipping Cost – Transaction Fees
Shipping Cost and Transaction Fees are used by most sellers when calculating gross profit because they are easily associated to a Sales Order (and then prorated per product).
Transaction fees make all the difference.
Transaction fees could be fees paid to a payment processor or marketplace. These can make a massive difference in your true profit vs. gross profit.
Example #1: Amazon Sale
- Amazon may charge 15% (depending on category) as a commission to sell on their platform (Source: Selling on Amazon Fee Schedule)
- Amazon is their own payment processor so there are no separate payment processing fees.
Example #2: eBay Sale
- eBay may charge 10% (depending on the category) as a commission to sell on their platform (Source: eBay Selling Fees)
- If the listing is paid with Paypal, Paypal charges the seller 2.9% + 0.30 per sale (depending on seller volume) (Source: Paypal Fees)
Example #3: Shopify Sale
- Shopify has its own payment processor and charges 2.9% + 0.30 per sale (depending on plan) (Source: Shopify Pricing)
Gross profit is the overall amount you take in.
Where true profit differs is it includes product overhead costs, which are any costs that can be allocated towards a product, either directly or indirectly.
Amazon offers a report called Monthly Storage Fees, which provides a monthly breakdown of storage fees per ASIN. Because the fees are per ASIN, you can associate the cost directly to a product.
Let’s say you use a 3PL which charges an Inbound receiving fee. If they charge $35/hour and it takes them 2 hours to receive a collection of goods, that cost is $70.00. There is no direct relationship between the cost and the product, however, if you know what products were part of the receipt, you can decide on a way to prorate the $70.00, allocated to the products. This may make sense prorated by weight, cost, quantity, or whatever measure you feel best correlates to the cost.
Many types of overhead can cut into gross profit.
- Monthly Storage Fees
- Long Term Storage Fees
- 3PL Prep Work or Fees
- Customer Return Write offs
- Customer Return Shipping Costs
- Listing Fees
- Other Inventory Losses (Some products may be more susceptible to shrinkage, damage, etc.)
Here’s the formula for calculating your true profit:
True Profit = Gross Profit – Product Overhead
You’ll also want to factor in your contribution margin.
The margin of True Profit / Product Revenue is often referred to as “Contribution Margin“, although for our purposes we are taking a much more granular approach by looking at the “contribution” on a per product basis rather than overall for the Income Statement.
Timing also makes a significant difference to your true profit.
True profit only makes sense to analyze over a time period of at least one month. Actually, the longer the period of analysis, the better. The reasoning behind this can be illustrated with the following example:
Let’s say you have an iPhone case, which on January 31st, produces the following numbers:
Product Revenue: $1,500.00
Unit Cost: $1,050.00
Shipping Cost: $80.00
Transaction Fees: $225.00
Gross Profit: $145.00 (~10% gross margin)
However, on that same day, you had a storage fee that occurred for $400.00 for the loads of inventory you have sitting in Amazon’s warehouse. The True Profit if analyzed on that day would be:
$145.00 – $400.00 = -$255.00 (-17% contribution margin)
This profit/loss figure is highly misleading. You may look at it and think: “Wow, I better stop selling this product because I’m actually losing money due to storage fees”. This is inaccurate because that monthly storage fee only happened to occur on January 31st, skewing the profit figure on that day.
You could of course try to amortize such costs, but that is far too much maintenance and work and totally unnecessary.
Instead, simply look at true profit figures over a date range of at least one month.
Tracking product profitability not just by Gross Profit, but also by True Profit, is essential for making smart e-commerce decisions.
Understanding true profit vs. gross profit can make the difference between a profitable product and one selling at a loss.
Or, when trying to decide where to place your inventory investment capital, you could be making the wrong choice by investing in a product with a seemingly higher margin, when in reality its true profit is lower than the alternative due to high storage costs for a bulky item, high return rate, high prep costs, etc.
The general philosophy here is that your income statement should put as many costs as possible “above the line”, that is, grouped into “Cost of Sales” rather than “Overhead”. Ideally, any variable cost should be allocated to the products that drive them.