The business behind an online brand: the nuances of ecommerce accounting
In this article, we’re going to discuss the underlying economics of a subscription-based ecommerce business. For all e-commerce businesses, first and foremost you need a brand that resonates with customers, a great product, and incredible customer service. Now that we’ve crammed a monumentally difficult effort into a single sentence, let’s move on to the financial side!
Like all companies, ecommerce businesses live or die based on their unit economics. The difference is, there is way more real-time, measurable, and statistically significant data with ecommerce companies than early stage enterprise SaaS businesses, for example. In other words, the data is there even at early stages, and there is no excuse not to use it to understand your business.
"GAAP isn’t enough. At the end of the day, are we turning a dollar into two dollars or a dollar into 50 cents, and if we’re turning a dollar into two dollars, how long does it take to do that? "
For subscription based ecommerce companies in particular, GAAP financials just don't tell you nearly enough about the true health of your business. Money is spent today to acquire customers that will generate margin and cash flow not just today, but down the line, and sometimes for very long periods of time.
While GAAP financials are required (especially once you raise institutional money), we strive to help our clients understand what's really happening under the hood. Are you turning one dollar into two dollars or one dollar into 50 cents? If you’re turning one dollar into two dollars, how long does it take to do that? You'd be amazed how many companies can't answer that question.
Let’s look at an example GAAP P&L for a company that is investing heavily in sales & marketing relative to their size. We’ll call this fictional subscription-based scarf company “Knitting Pretty.”
At first glance, Knitting Pretty is spending way more than it makes and looks like it’s in a lot of trouble.
But let’s look at what’s really happening. For a subscription-based business, retention is crucial. You can have the best and most effective marketing in the world, but if people aren’t head over heels for your brand and product, your economics will ultimately suffer.
We look at retention in a number of ways, but in particular, we tend to look at monthly cohorts. Before we take a look at whether Knitting Pretty has a healthy business, let’s identify a few terms first.
What exactly is a cohort?
Never heard of a cohort? No problem! The truth is many accountants are not familiar with the concept either. A cohort is a group of customers that purchased from you for the first time in a given time period (usually a month). It’s sort of a “3D” view of an otherwise “2D” analysis.
That itself still sounds pretty abstract, so here’s an illustration. Let’s pretend Knitting Pretty opened for business and first sold its scarves in January.
As you can see, cohorts stack on top of one another, and the sum of the column in any given month is your GAAP revenue for the month.
Retention is everything!
Now that you’ve acquired a customer for your subscription scarves, retention is everything!
We’d look at retention rates for that particular cohort of customers. Let’s say we made $50k in revenue from a given cohort of customers in the first month of their ordering. We’d peg $50k as the denominator and compare how this group does in later months.
It is extremely common to have a large drop-off in the early months due to customers just trying things out. After a certain period, retention tends to level off due to customer habituation and re-engagement.
So how does this all tie together?
Let’s look at the unit economics for the January cohort. Is this sustainable, or is the company ripping through their cash reserves and accelerating off a cliff? The graph illustrates how much the company spent to acquire customers and then how much the company made in gross profit from that particular cohort of customers over time.
We’re making the following assumptions:
As you can see, Knitting Pretty breaks even in about five months on ad spend. To take the above figures to the unit level, divide the numbers above by the number of new customers acquired, now you can answer the question "what are we spending to acquire a single customer on average, and how much do we make from a single customer on average?" These are also known as CAC and LTV.
In this example, the customer payback period is five months. All gross profit derived after that contributes directly to the bottom line and can either be used to fuel growth or can, of course, be taken as profit.
It’s important to note that when looking at LTV, you should use gross profit and not revenue. Using revenue will make your payback period look a lot shorter than it really is.
So taking it back to illustration 1. Knitting Pretty blew through $100k in a single month. Is that a healthy business model?
Well, the good news is, you now know that, as painful as it is to see, and can now correct course.
If your ecommerce business is not subscription-based, the math is still the same, only accelerated. For a one-time purchase (or once every several years type of purchase), your CAC must be less than your gross margin on order #1. From there, view reengagement from previous customers as icing on the cake from a financial standpoint.
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1. Generally accepted accounting principles (GAAP) refer to a common set of accounting principles, standards, and procedures issued by the Financial Accounting Standards Board (FASB).