The Accounting Oversight

Caroline was using accrual accounting, which is great for matching revenues with expenses in the period they occur. However, she was only accounting for the “buy cost”—the price she paid her suppliers for the products.

She overlooked the landed costs, which include:

• Inbound Freight: The cost of shipping the products from the supplier to her warehouse.

• Customs and Duties: Fees charged by the government for importing goods.

By ignoring these additional costs, Caroline was understating her Cost of Goods Sold (COGS) by 46%!

The Impact on Profit Calculations

Because her COGS was understated, Caroline’s gross profit appeared much higher than it actually was. This inflated profit number was then used to calculate the incentives for her ads agency. Over the last quarter, she ended up paying the agency $84,000 more than she should have.

How Gross Profit Should Be Calculated

Gross Profit = Sales Revenue – COGS

Where COGS (cost of goods sold) should include all costs to get the product to a state of being ready to sell, namely the LANDED COST:

• Buy Cost: The supplier’s price.
• Inbound Freight: Shipping costs to your warehouse.
• Customs and Duties: Import fees.

By omitting inbound freight and customs, Caroline’s COGS was missing substantial expenses, leading to an inaccurate gross profit for the last quarter. Her last purchase order shipment arrived 4 months ago and her bookkeeper did NOT add the freight and customs to the inventory balance but rather expensed it as paid. What a mess!

The Domino Effect

This accounting mistake didn’t just affect agency fees. It had several other repercussions:

• Misguided Business Decisions: Caroline invested in products and marketing strategies based on inflated profit margins.
• Cash Flow Issues: Overestimating profits can lead to overspending and potential cash shortages.
• Tax Implications: Incorrect profit reporting can result in tax complications down the line.

How Caroline Fixed the Problem

Realizing something was off, Caroline consulted with CronosNow who specializes in e-commerce. Here’s how the problem was fixed::

• Recalculated COGS: We included all landed costs—buy cost, inbound freight, and customs—in her COGS calculations.
• Adjusted Financial Statements: We updated her financial records to reflect the true landed cost based COGS and profit figures.
• Renegotiated Agency Terms: Caroline then discussed the oversight with her ads agency and renegotiated the incentive structure based on accurate numbers.
• Implemented Better Accounting Practices: We set up systems to ensure all costs are accounted for in the correct periods.
• Setup a process for recording inventory: We helped to setup a proper process for recording inventory at landed cost and processed the related COGS using these updated numbers. We then implemented a tool called SellerVue (www.sellervue.com) along with a2xaccounting to drive an accurate COGS and gross profit figure.

What You Can Learn from Caroline

1. Understand Landed Costs

Landed costs are all the expenses involved in getting your product from the supplier to your warehouse. This includes:

• Product Cost: The price paid to the supplier.
• Shipping Costs: Fees for transporting the goods.
• Import Fees: Customs duties and taxes.
• Insurance: Protection against loss or damage during transit.

2. Use Accrual Accounting Properly

Accrual accounting matches revenues with the expenses incurred to generate them within the same period. This gives a more accurate picture of profitability.

Ideally a full inventory system or even ERP is used to drive these numbers, but for most ecom sellers the a2xaccounting or linkmybooks tools will give you a more than accurate enough COGS figure.

3. Regularly Review Financial Statements

Periodic reviews can help catch discrepancies early. Look at your profit and loss statements, balance sheets, and cash flow statements regularly.

Most importantly, there is an easy hack that any business user can do

1. Export your income statement (also called profit and loss statement) to a spreadsheet showing the last 12 months;
2. Calculate the Gross Profit percentage as gross profit divided by net revenue.
3. This GP% should be very stable over time, if this is not the case you probably have a landed cost problem!

4. Consult Professionals

Don’t hesitate to seek advice from accounting professionals who understand the nuances of e-commerce.

Tips to Avoid Caroline’s Mistake

• Automate Accounting Processes: Use accounting software (a2xaccounting or linkmybooks along with sellervue is an ideal solution) that can track and allocate landed costs automatically.
• Educate Your Team: Ensure that anyone involved in financial decisions understands the importance of accurate COGS calculations.
• Monitor KPIs Closely: Keep an eye on gross profit margins and investigate any unusual fluctuations.
• Communicate with Agencies: Make sure external partners are working with accurate data.

Conclusion

Caroline’s story is a cautionary tale for all e-commerce founders. Ignoring landed costs can significantly distort your understanding of profitability, leading to costly mistakes like overpaying agencies or making poor investment decisions.

By taking the time to properly account for all expenses, you can ensure that your profit calculations are accurate. This not only helps in making informed business decisions but also safeguards your hard-earned money.

Are you confident that your profits are calculated correctly?

Cash basis vs Accrual. Simplified example:

Here is a simplified example of some of the differences between the two types of accounting. In this example, Jim sells high-end hammers on Amazon and Shopify. This is how the transaction would look under each type of accounting:

• Jim buys 1000 hammers for $10 each ($10 000) in October and pays cash for it
• He sells it in November for $30 each ($30 000)  with a net 30 days payment terms
• The customer pays $30 000 in December for the product they purchased

The Problem: Misleading Financials Due to Cash Basis Accounting

Cash-basis accounting is simple.  Revenue is recognized when cash is received, and expenses are recorded when cash is paid.

Jim’s situation highlighted a common problem many eCommerce sellers face, especially when managing inventory and the cost of goods sold (COGS).

Under cash-based accounting, Jim’s inventory purchases were expensed as soon as payments were made, which meant his income statement showed large, sporadic expenses depending on when he bought inventory. Meanwhile, his revenue was recorded when cash came in from sales. What made things worse was that the value of the inventory he had on hand was not being tracked at all.

This mismatch caused several issues:

• COGS didn’t match revenue: Jim couldn’t clearly see which sales were driving profits because his COGS were all over the place, not tied to the periods when he actually sold the goods.
• Inventory wasn’t tracked properly: His balance sheet didn’t reflect the inventory he had in stock, making it difficult to understand the true value of his business.
• Bank balance misled him: Like many cash basis users, Jim was relying on his bank balance to gauge the health of his business. But with large upfront inventory payments, his cash flow looked worse than it was, and he wasn’t seeing profits in real-time.

As a result, Jim thought he was doing well based on revenue, but his business felt cash-strapped. He couldn’t understand why he wasn’t seeing more money in his own pocket despite the growth.

In Jim’s case, he was constantly placing large inventory orders to keep up with his booming sales.  These orders required significant upfront payments to suppliers. Under cash-basis accounting, these payments were immediately expensed, making his profit margins appear razor-thin (or even negative) even though the inventory hadn’t yet been sold.

Our Solution: Switching to Accrual Basis Accounting

When Jim partnered with us, we immediately recognized the need to switch him to accrual accounting.

Why Accrual Accounting is better

Accrual accounting provides a much clearer picture of profitability by matching revenues and expenses to the period in which they are earned or incurred, regardless of when cash changes hands.

Accrual accounting allows businesses to record revenue when it is earned (not just when the cash is received) and expenses when they are incurred (not just when payments are made). This change had a dramatic impact on how Jim viewed his business:

• Revenue Recognition: Instead of recognizing revenue only when Amazon settlements or Shopify payouts were paid, we recognized it when the orders were created, providing a more accurate view of sales performance. 
• Sales-related fees recorded: We also recorded the revenue from sales separately from the Amazon and Shopify fees. Compared to previously only the net receipt into the bank being recorded as revenue.
• Cost of Goods Sold (COGS): We calculated COGS based on the inventory sold during the period, accurately matching expenses to the corresponding revenue. This gave him an accurate picture of profitability for each month with COGS “matched” to revenue.
• Inventory on the balance sheet: Instead of expensing inventory purchases immediately, we recorded his inventory and any inventory deposits as an asset on the balance sheet. This helped Jim understand how much product he had available for future sales and how much he had already paid for it.
• Clear financial performance: Jim could now see not just his top-line revenue separately from selling fees, but his gross profit and net profit, as well as the value of his inventory in stock.

The Results: Turning a Loss into a Profit

Once we made the switch to accrual accounting, Jim’s financials completely transformed. 

After transitioning to accrual accounting:

• Jim’s revenue increased from $5.7 million to $7.3 million with selling fees shown separately and $150,000 “receivable” for funds held by Amazon and Shopify
• His net loss of $300,000 transformed into a net profit of $1.2 million.
• His balance sheet now accurately reflected $1.5 million in inventory assets and deposits for future inventory orders.

Jim now had a much clearer view of his business. He could see that his company was profitable and that he had not “lost” another $300,000 but that he had in fact invested that into inventory assets to keep up with a healthy growing business needs.

The adjustments allowed him to make more informed decisions about growth, inventory purchases, and cash flow.

The Power of Accurate Accounting

This dramatic shift in Jim’s financial picture wasn’t due to any magical increase in sales. It was simply the result of using the right accounting method to reflect the true performance of his business.

Accrual accounting gave Jim the insights he needed to:

• Understand his true profitability: He could now see how much money his business was actually making.
• Make informed decisions: With accurate data, he could confidently invest in growth initiatives, knowing his business could support them.
• Secure funding: Accrual-based financials are essential for obtaining loans or attracting investors.
• Reduce stress: Understanding his financial position gave Jim peace of mind and allowed him to focus on growing his business.

Jim now understood that he had a profitable and healthy business. He used the newly discovered high-quality accounting and growth projections to get a 2-year loan with a low APR% and monthly repayments so that he could afford to fund the growing inventory needs and felt comfortable doing so while starting to pay himself a reasonable salary.

Key Takeaways

If you’re an e-commerce entrepreneur relying on cash-basis accounting, it’s time to consider making the switch to accrual accounting.This is especially crucial if your business is:

• Experiencing rapid growth
• Carrying significant inventory
• Seeking funding
• Struggling to understand your true profitability

Don’t let your accounting method hold you back.  Partner with an experienced e-commerce accounting firm to ensure your financial data is accurate, insightful, and empowers you to make the best decisions for your business.

Are you on cash basis or accrual basis accounting now? Most e-com sellers are not accounting experts, and are not 100% sure if they are using cash basis or accrual basis bookkeeping. An easy way to tell. Look at your balance sheet, is there a line item for inventory?

If not, and your cost of goods sold appear only to be aligned with the payments you have made to your suppliers, then you are on cash basis!

Remember that not all accrual basis accounting is of a high quality, but any accrual basis attempt is better than cash basis only.

Joe messed up. He ignored VAT

Joe, however, messed up. He did not consider UK VAT requirements. He thought he was just testing the market. He happily sold to customers in the UK while shipping from the USA. His average order value was below £135, so he thought he was fine.

His sales, however, skyrocketed, and he scrambled to keep up with the order volume. As the orders were below £135, Joe initially did not consider the VAT thresholds. However, since 2021, the UK has required VAT on low-value goods sold into the UK from outside the country. This meant Joe should have charged VAT on all sales under £135 and filed VAT returns with HMRC to pay the amount owed.

How Joe went from a $150 000 profit to a $88 000 loss

Joe had never charged his customers VAT, so now he had to calculate the VAT out of the revenue and profits he had already charged his clients. This is how the numbers panned out:

• In the past eight months, Joe had sold $1 million, or £755,000, in the UK.
• Joe had a healthy 15% net profit margin, so he was expecting to turn a net profit of $150 000
• But instead of charging £40 plus 20% VAT, making a total of £48 (with £8 belonging to the UK government), he had only charged £40.
• Now, he had to calculate the VAT from his profits: £40 x 20/120 equals £6.67, which he was required to pay to the tax authorities.
• As a result, the VAT, which he could no longer charge back to his customers, had to be calculated from his profits. This came to £755,000 x 20/120, equaling £125,833 in VAT.
• On top of that, he faced interest and penalties for late payment, bringing the total amount owed to $238,000 when converted back to USD.
• So Joe went from thinking he made $150 000 net profit to making a $88 000 loss because he did not consider the VAT implications of selling into the UK

What should Joe have done?

If Joe had planned to test the UK market while shipping products from the USA, and knowing his average order value would be under £135, he should have registered for UK VAT through the simplified One Stop Shop (OSS) scheme, a simplified VAT reporting approach available since 2021.

He would then have set up his Shopify store to automatically add 20% VAT to all UK orders at checkout. This way, on £755,000 worth of sales, an additional £151,000 in VAT would have been collected and paid to HMRC, ensuring compliance and maintaining profit margins without unexpected tax liabilities.

Does this sound like a lot of admin and cost to setup if you are just testing?

If Joe had been smart, he would have done one of the following:

Option 1) Use Shopify Managed Markets

Testing a new market can be challenging, especially with the added complexity of VAT and regulatory requirements. Joe could have set up Shopify Managed Markets, which would have eliminated compliance risks for selling into the UK. This service, provided by Shopify in partnership with Global-e, manages VAT OSS filing and reporting, acts as the importer of record, and ensures that the correct taxes are applied in the Shopify store.

However, since Joe sells supplements—a category that Global-e often restricts due to high compliance requirements—this option may not have been available. In that case, Joe could have pursued an alternative plan to ensure compliance.

Option 2) Partner with a service provider

Joe could also have partnered with a service provider that sets up UK operations under a separate legal entity. These partners are experts in local compliance and logistics, adding value to the sales process with their knowledge of marketplaces like Amazon and even wholesale clients. A great example is Atlantic Access.

This option might have been even more beneficial for Joe, as it allows his brand to remain intact while a local partner manages the operations. This turnkey solution would have freed up Joe’s time and resources to explore other growth opportunities, such as new sales channels or products, while still expanding into the UK and EU markets with stronger results.

If Joe had used such a partner, the partner would have acted as the “buyer” in a wholesale relationship, becoming the importer of record. They would have handled all VAT obligations and, for orders exceeding £135, any customs duties—taking care of all compliance and cost management, leaving Joe without the hassle or expense.

How did we help Joe get out of the mess?

So for Joe, his testing had exceptional results and therefore, there was already showing a business with critical mass.

We helped him set up his UK VAT registration NOT under OSS but under the full UK VAT registration as he was well above the UK VAT threshold of £85,000 in taxable turnover over a 12-month period. Joe set up an agreement with a 3PL and moved large amounts of inventory into the UK in two warehouses, so he now had physical inventory inside the country to speed up delivery times.

How is Joe doing now?

Joe now imports products in large quantities, paying customs duties and a portion of import VAT based on the cost price of his products—some of which he is able to claim back.

His Shopify store is configured to automatically charge 20% VAT on all UK sales, and we assist him in managing the import VAT deductions. Additionally, we help him claim VAT deductions on other expenses such as local agency fees, 3PL services, and advertising, effectively minimizing his overall VAT liability.

Joe now files quarterly VAT returns, and we provide him with monthly updates on his liability to ensure he stays informed. To manage his VAT obligations effectively, we set up a separate bank account where the collected VAT is set aside, as it does not belong to him. This VAT is charged at checkout on top of his product’s selling price for all UK customers, ensuring proper compliance and financial management.

We also engaged with the HMRC on his behalf The HMRC waived penalties on the back taxes and provided a 24-month payment plan for the previous inferred VAT amounts that were not collected. 

This still hurts, and Joe still regrets not having gotten a good finance and accounting team earlier, but this is all part of the learning journey and is nothing other than school fees. 

He is now planning a second expansion to the European markets, but VAT and tax compliance are things he is starting with as part of this plan. Lessons learned, risks managed, and back to focussing on growth.