How the 4 Margins Explain Where Profit Disappears To

I'm Stephen Brown, host of the Ecommerce Finance Podcast, also COO here at LedgerGurus. With me I have Stacy Walker, Director of Growth here at LedgerGurus. And today we're going to talk about four margins. What they are, why every ecommerce brand should track them, why they matter, and why they are often wrong.

Hi Stacy, thanks for joining us.

0:27 Stacy Walker

Thanks for having me, Stephen. I'm excited to visit with you today about margins and how our customers and prospects can learn more.

0:35 Stephen Brown

How many brands do you usually talk to in a given week?

0:39 Stacy Walker

I would say between 8 and 15, depending on the week.

0:42 Stephen Brown

Now, one of the things I've heard from you and the other members of the growth team is customers often come to us because they don't feel like they understand their profitability. Is that accurate?

0:52 Stacy Walker

Yeah, they definitely don't understand profitability and they don't understand margins.

And it's interesting when I'm talking to them, so many of them don't even realize that there are different margins that they should be tracking, or why they would even care about different ones.

1:07 Stephen Brown

So what are the questions they have about profitability when they come? You're usually the first person they talk to. What questions do they have around profitability?

1:13 Stacy Walker

Almost always profitability comes around inventory, and if their costing is right, and if they're selling at the right price.

You'd be surprised how many people don't know the difference between cost of goods sold and cost of sales. In fact, Stephen, maybe we should take just a second and talk about that.

1:33 Stephen Brown

Before we do that, I want to dig a little bit deeper at the higher level.

We're talking to seven and eight figure brands, and sometimes multiple eight figures. How often do you feel like they have an accurate sense of their bottom line profitability?

1:47 Stacy Walker

20% of the time. Almost never.

1:49 Stephen Brown

20% of the time.

So okay, let's go down. We'll introduce the four. Most people understand about net profit margin, but it sounds like a lot of times they're not confident that what they have is accurate.

2:05 Stephen Brown

The margin at the very top is the gross margin, which really is net sales minus your cost of goods sold. How often do you feel like people understand gross margin and have accurate gross margin calculations?

2:16 Stacy Walker

Oh, they almost never have accurate gross margin calculations. Almost never. I would say 10%. And they just don't know.

2:19 Stephen Brown

I would agree. 10%. I think that's generous.

Would you say 10% are accurate, or 10% know what it is?

2:32 Stacy Walker

10% know what it is and are accurate. I think most people know what it is, they just don't know how to get to it.

2:39 Stephen Brown

I think it's lower than that. I've talked to a lot of customers and they confuse gross margin with contribution margin, which is the next one down the stack.

Now, contribution margin is typically your gross margin minus your selling costs, divided by income. How often would you say people understand the concept of contribution margin?

2:55 Stacy Walker

Nobody ever understands the concept of contribution margin, or they think contribution margin is gross margin.

3:07 Stephen Brown

I would 100 percent agree.

And this is, we're talking about large brands. The one I'm sure that nobody ever talks about is net operating margin. This is one that I like to look at.

3:25 Gross margin, and where profit leaks from inventory

Stephen Brown

So let's talk about the four margins, how they're calculated, why they matter. Let's talk about gross margin.

Now, at its simplest level, gross margin is your net sales minus your cost of goods sold.

3:40 Stephen Brown

One of the big issues I run into is people stuff cost of goods sold with a lot of things that really are cost of sale.

So in a standard accounting world, cost of goods sold typically is your landed product costs, the costs of the goods sold. But I see a lot of people stuffing merchant fees in. I see a lot of people putting fulfillment costs into the cost of goods sold. And that skews things.

3:56 Stacy Walker

Yep. Ad spend, because they think that's what costs it, that's part of selling it. They wouldn't be selling it without ads.

4:01 Stephen Brown

Sometimes they do ad spend as well.

This comes from whoever set up profit and loss statements, the nerd accountant powers that be. There's a cost of sales section, or a contribution margin line item. So I think people are like, well, I want to see what my variable costs are, so I'm going to shove them all into cost of goods sold.

4:23 Stephen Brown

Now, we run into a lot of people that want a better understanding of their gross margins.

4:27 Stacy Walker

Yeah, they definitely do. They look at their books, they know something's missing. The problem is they don't know what is missing.

So why do you think that is, Stephen? Why do you think margins are such a huge misunderstood area for ecommerce sellers?

4:46 Stephen Brown

Well, one, I don't think a lot of people understand accounting and they don't understand what it tells them. But they do have a sense of things.

I am a non-accountant, I'm a dumb MBA, but I do CFO work. I guess I'm not so dumb.

5:00 Stephen Brown

The reason, one, it's a standard. It's a best practice that cost of goods sold is just those product costs.

But I feel like when you track that individually and you're looking at that as a percentage of income. So what percentage of income is your cost of goods sold? And the inverse of that would be your gross margin. So when I subtract the cost of goods sold from my net sales, and I take that gross profit divided by the income, that's my gross margin.

5:30 Stephen Brown

That I want to track in isolation, because it really tells me what's going on with product costs. And product costs, we look at our cost of manufacturing, the cost of importing, tariffs. If you're doing your own manufacturing, that could be direct labor, it could be direct materials. So there are different ways you come up with that.

5:55 Stephen Brown

The reason you want to track that differently, and I think the last couple of years have really been illustrative on this point, cost of goods should stay fairly static if you do it as a ratio.

So when you take cost of goods sold divided by your income, that's a percentage, and that shouldn't change too much. Now there's some variation just because of timing, and different shipment costs can vary. But for the most part, if I look at it on a chart, it's kind of a flat line.

6:17 Stephen Brown

But the last couple of years, we've seen supply chain issues, so that importing cost goes up, you get big spikes. We've seen obviously the tariffs have really cranked up the costs. We've seen inflation, which can drive up baseline costs.

And so the reason why it's nice to break that out and monitor it separately is, if that goes up then you're getting margin erosion down at your profit level.

6:43 Stephen Brown

And so when I think about that, if my cost of goods sold is going up, what are my options? Well, I can negotiate better terms with suppliers. A big one is adjusting pricing. I can try and re-engineer my supply chain.

But I think for many years, decades, we've seen these underlying costs be fairly stable, and therefore haven't had to worry about them. But now we do. And if you're not tracking it, you're like, hey, where's all my profit going? Well, it could be going into cost of goods sold. But because you're not tracking it accurately, you don't know why you're losing profits.

7:16 Stacy Walker

And I think that's exactly what we're seeing, especially the last couple of years, with supply chain, with tariffs. That's why people suddenly are like, where's my money going? Why do I think I'm making more than I've ever made, but I have less cash in the bank than I've ever had?

7:33 Stephen Brown

Yeah, you bring up a good point. A lot of people track the health of their business on cash in the bank. When on a profit and loss statement done accurately, you could have massive amounts of profit and you're like, where's my cash? Well, it gets tied up in inventory, which relates back to cost of goods sold.

This is one of the biggest problems I think we've run into. Good cost of goods sold and inventory accounting is based on good inventory management, and a lot of people don't do a good job with that. And so you get a lot of leakage.

8:02 Stacy Walker

Yeah. And I see this every day. So often people don't realize that inventory has an operational side and an accounting side.

And if they feel like they have their operational side dialed in, then they think that inventory is fine. But they have no idea what's going on with costs. So here we are with COGS off the charts compared to say last quarter, even last year, and they don't realize until it's been a hot second.

8:33 Stephen Brown

And I talked about some key issues that you want to monitor in the most recent years' macroeconomic environment. But there are other ways in which you can have profit leakage from cost of goods sold problems.

So that would include things like damaged inventory. You brought in a bunch of inventory, somebody backed a forklift into your box and boom, that wasn't tracked.

9:00 Stephen Brown

There is theft. I don't care whether you have your own warehouse or you're using a 3PL, people could swipe some goods. If you have an expiration date on your inventory, it could expire. There is lost inventory. And all that comes back to inventory management.

9:20 Stephen Brown

And we oftentimes will capture those issues when we work with a customer who really gets serious about inventory. We say let's do an inventory count, they do a count, and they're like, hey, the books say the inventory is worth this much, we counted that much, there's a difference. What gives?

And when you start peeling back the data, you're like, well, this got damaged, this got lost. And people just don't know. And this is like the white whale we've been chasing with our customers for years, because it's really hard, but it's so important to do.

9:45 Stephen Brown

Because you're losing profit, and or you're losing signals.

There are two things. The things we started talking about, those are things you can take action on, with pricing, with supplier relationships. The latter is operational stuff that might not be a big number, but over time as it adds up, a percent here, a percent there, really can become a big problem.

10:11 Stacy Walker

Yeah. Didn't you tell me that your ecommerce brand, that your 3PL let you know that they found a whole pallet of stuff that had been lost in the warehouse?

10:22 Stephen Brown

Yeah. We bought the business and then they said, oh, we found a pallet, and all the inventory's expired. We're like, crap. Because we're doing skincare and there's a shelf life to it. We're like, well, that's great.

10:35 Stephen Brown

And I've been to the warehouse. I've been to a handful of warehouses and you kind of expect them to be really cool, like you see on videos like Amazon. They're not.

And I'm sure Amazon loses and damages inventory, there's a whole industry there that helps get refunds on that. It's just the reality of warehouses, stuff happens. And whether you're managing it yourself or you're using a 3PL, you need to keep your eyes on that and understand if there's leakage, and why.

10:55 Stephen Brown

I'll give you a good story. A couple of years ago we had a customer that hadn't done a count in years. We had told them, guys, you really need to do a count, you really need to do a count.

And they had an opportunity to sell the business. So they went to sell the business, they did a big audit, and they're like, oh, your value on the books is very different than what you have in the warehouse.

11:29 Stephen Brown

And they had to write down that whole value at one time, when really it probably represented three to five years of value.

Well, what was the buyer paying on? They're paying on profitability in the last 12 months. Well, that big write down got applied all at once. So it really discounted.

11:43 Stephen Brown

If you think about it, that cost of inaccurate inventory management was much more than that difference. It was a multiple, because usually you're getting paid on multiples of profit.

So there are a lot of reasons. I would say at minimum you should be doing good cost of goods sold so that you can make sure that your pricing isn't deteriorating. But ideally also operational leakage. Are you losing one, two, three points of profit due to sloppy operations?

12:11 Stephen Brown

And that's where the gross margin tracking can uncover that, if it's done right. Which is really hard to do.

What are customers, when they're talking about inventory, accounting, and gross margins with you, you're at the tip of the spear, what are some of the questions they're asking? It sounds like they sense there's a problem, but what is their initial understanding?

12:40 Stacy Walker

Yeah, they definitely sense there's a problem, and there's definitely frustration around the fact that there's a problem. They don't know how to solve it.

I would say the biggest thing that I'm seeing is they're trying to track things in spreadsheets. So take a business that sells three widgets. You can probably track your costs and everything in a spreadsheet for years. But now all of a sudden you're talking to a customer that has five thousand SKUs.

13:03 Stacy Walker

And they're trying to update costs every month or every couple of weeks as they're ordering. And it's just too hard, you can't do it. You can't stay on top of it and not have it be accurate. There are just too many touch points where human error could come into place.

And think about it, one transposition of the numbers and you could be totally off the rails and not know it.

13:24 Stephen Brown

And when you start dealing with suppliers, you've got multiple orders coming in.

13:29 Stacy Walker

Multiple sales channels. It escalates so quickly.

13:24 Contribution margin, and what good margins look like

Stephen Brown

Let's talk about the next margin, contribution margin. This is something that I feel like nobody in seven and eight figure ecommerce land really understands. But they really should.

13:40 Stacy Walker

Some of them don't even know what it is. I've talked to a few people recently that I asked them about their contribution margin and I end up having to explain to them what it is.

13:47 Stephen Brown

Well, I would even argue there could be a debate over what a contribution margin is.

At a high level, contribution margin would be your gross margin minus your cost of sales. The cost of sales are costs that are only incurred when you sell. The things that are really easy to say is fulfillment. I am never going to pick, pack, or ship unless I sell a product. I'm never going to incur payment processing fees unless there's a sale.

14:20 Stephen Brown

The one I like to argue, and I've heard people do two things, is what about advertising? Should that be included in your cost of sale, or is that separate?

And I've seen some people do both. They'll do contribution margin with advertising, contribution without. For a direct-to-consumer brand, there's a part of me that says you would not have sales without advertising.

14:41 Stephen Brown

So I like to layer it in. But I can also see, and I think if you're really savvy, you could look at both.

Now, what does this tell me? This tells me the selling efficiency. If you think about it, these two ratios tend to be fairly consistent as a percentage of sale.

15:00 Stephen Brown

So let's say my cost of goods sold is 20 cents on every dollar. So every time I have a sale, my gross margin is 80 cents.

And let's say I have cost of sale, fulfillment. Let's say fulfillment's 10%, processing fees is usually about 3%, so that's 13. Advertising's all over the place, that's where the argument could be to keep it out. The other two tend to be fairly consistent month to month, or on average.

15:30 Stephen Brown

But advertising, I've seen it range from 20 to 35% or more of sale.

So let's add that up. Let's just take a round number, 30% plus 13 is 43. I make a sale, 20 cents of that goes to the cost of goods. Another 43 cents of that goes to the cost of sale. What's left over? Let me do the math. 37 cents.

15:55 Stephen Brown

And it's not unusual to see that. But basically what that tells me is what's left over. Every time I sell, I don't care how many units of widgets I sell, I'm only going to be left over with a certain percentage of that sale after all of this other stuff. It just has to happen with the sale.

And the challenge you run into is if you have a really low contribution margin, then you have no room for operating expenses and profit.

16:15 Stacy Walker

So you say if you have a really low one. What do you think is an ideal contribution margin for an ecommerce brand?

16:21 Stephen Brown

Well, we should back it up. What do you think an ideal gross margin is?

16:24 Stacy Walker

Ooh. 50%.

16:26 Stephen Brown

I think it varies. So the answer is it depends.

If you're looking at getting lending, a lot of people want gross margins at a minimum of 40%. So that means your cost of goods sold is 60%. Now, that is really hard, to run a consumer products brand on 40% gross margins.

16:51 Stephen Brown

The ones I see that are lower gross margin tend to be resellers. Somebody that's selling a product that's not theirs, like M&Ms, or somebody else's brand.

Because the challenge with that is there are a lot of other people out there selling it. Your pricing power is almost zero, because the manufacturer's going to give you the manufacturer's suggested retail price, and there's competition. The prices tend to normalize when you're reselling product.

17:20 Stephen Brown

That's why you get big, like I think Costco has a really low gross margin, but they make it up with volume. If you're a small seller, you don't have that capability.

If you're a direct to consumer brand, your gross margins really need to be closer to like 70. If they're not, you don't have enough dollars left over to capture demand.

17:45 Stephen Brown

Like if I'm selling a known good, I can do SEO and do demand capture for less cost. But if I have something like the product we have, Solé Toscana, skincare, I've got to make people aware of that product and help them understand why they need it. So I have to spend more on advertising.

18:01 Stephen Brown

Either way. So let's go down to contribution margin. What is a good contribution margin? It really depends.

Usually what I've seen is, higher gross margins, you can spend less on advertising. Lower gross margins, you usually need to spend more on advertising.

18:16 Stephen Brown

I think the best contribution margins I've seen are around 40%. I would say 20 to 30 is not uncommon.

18:21 Stacy Walker

Oh wow, that high? That's good.

What do you consider healthy though? What you're seeing may not be what you consider to be the healthy margin.

18:34 Stephen Brown

I think the smaller you are, there's not a really right or wrong answer. Like a Costco, they have low contribution margin, they have low gross margins.

Whatever your contribution margin is dictates how much you can spend on operating expenses. And the problem with it when you're small is there's a base level investment you need to run the company.

19:00 Stephen Brown

If you think about it, the same creative that maybe drives a million dollars of revenue, executed well, could also drive $10 million of revenue. Whether that's a person on staff or an agency generating that creative, there's a baseline cost.

Let's say you have an R and D team that's doing product development. The cost of designing a phone case, I've got my phone here, the design cost is going to be essentially the same regardless of how much you sell.

19:29 Stephen Brown

So I think the challenge you run into with contribution margin is, when you're smaller you need more contribution margin to support that fixed cost. But as you scale, fixed costs should get smaller as a percentage of income, because you don't need to scale those with the growth of your business.

19:50 Stacy Walker

Stephen, do you think there's ever a point where contribution margin becomes more important than gross margin?

19:56 Stephen Brown

No, because they're each telling you different things.

If my gross margin goes down, I want to dig in and see what's going on. Is it more tariffs? Are underlying manufacturing costs going up? Do I have leakage or inventory management issues?

20:15 Stephen Brown

If my contribution margin goes down but my gross margin does not, then I want to dig into those cost of sales. Have my fulfillment costs gone up for some reason? And if you're including advertising into your cost of sale, which I like to, that's the most likely culprit, is advertising efficiency deteriorates.

So I'm watching those things because they're going to tell me different things.

20:34 Stacy Walker

When you talk to some of our brands that you're working with, you do a lot of our advisory, are they ever surprised to learn about contribution margin, and the critical role it plays in their financials and the health of their business?

20:54 Stephen Brown

I think they're more confused than they are surprised.

I think it's an abstract concept a lot of people haven't wrapped their heads around. It's not on the P&L, so I have to do some reporting, or I do some dashboarding to show them. And it's confusing. They're like, I don't get this concept.

21:13 Stephen Brown

But those that do, and are watching it, they're at another level.

A lot of times what I see, let me back it up with gross margins. I can see pretty quickly if gross margins aren't being calculated accurately. If I graph it and it's not somewhat flat in nature, then I'm like, okay, do we have some underlying cost increases? Like last year, I'll ask about tariffs.

21:23 Stacy Walker

What's your trigger? What tells you that?

21:37 Stephen Brown

A lot of people understand their input costs somewhat well. Did tariffs affect you? But if the answer was no, or we adjusted, and it's not flat, then usually we have to dig in for a multi-month or longer effort to help them shore up their processes. But we can help them on the accounting front, we can't help them on the operational front, like you said.

21:57 Stephen Brown

So when it comes to contribution margin, I think it's more like, that's interesting, what do I do with it?

And what I do with that is I'm monitoring to see that cost of sales are not causing issues. If I include advertising as a cost of sale, which I think is debatable why you should or shouldn't, advertising is hard to maintain a consistent efficiency.

22:18 Stephen Brown

There are times a year where you can get a lot of bang for your buck, and there are times a year where you're really investing. And so that's an argument for having contribution margin not include advertising, or having two metrics.

Some of these should be fairly flat in nature. Cost of goods sold, fulfillment costs, your merchant fees are going to be fairly consistent as a percentage of sale. Advertising typically is not. But if you look at it over a longer period of time, like a 12 month period, and you see it creeping up, that's a big signal that something's wrong. Something's not working.

22:55 Net operating margin, payroll, and fixed costs

Stacy Walker

Should we talk about net margin?

22:55 Stephen Brown

Let's talk about net operating margin. This is one that most people don't do.

I typically like to take non-operating expenses and put them down into other expenses, and income into other income. The net operating margin tells me how efficient the business is.

23:07 Stephen Brown

So things that I like to put in those other categories, things like interest, I like to push interest down into other expense. Why? That is not a measure of how effective the business is. That is a measure of how effective your capitalization of the business is.

23:35 Stephen Brown

So you could have two different buyers that have two different capitalization structures, meaning they have more cash, they have lower cost lending. But if I include interest up into my operating expenses, that blurs things.

Whereas if I move that down, net operating income in some ways almost turns mine into an EBITDA. Earnings before interest, tax, depreciation and amortization. So all the ITDA stuff, I like to push down into other expense. So then I can see what the underlying efficiency of the business is.

24:10 Stephen Brown

And usually when you're talking about net operating margin, you're taking your contribution margin and then you're subtracting operating expenses. So your payroll, your software, rent, travel, business lifestyle expenses.

24:24 Stacy Walker

So what I feel like I'm hearing you say is the net operating margin is how the business owner can tell if the business is sustainable or not.

24:34 Stephen Brown

Yeah, to a certain extent it is. If I add all these operating components.

Let's say I have a really good contribution margin, 40%, but my net operating margin is low. That tells me I've got a lot of overhead.

Now, there are a couple of reasons why you may have a lot of overhead, but there's one in particular that is the most common culprit.

24:56 Stacy Walker

What is it?

24:57 Stephen Brown

Payroll. That's usually the biggest operating expense.

Now sometimes I see people that have too much rent. I used to see, not as much in the last couple of years, but there used to be a lot of lifestyle stuff going on. You'd have lunch in the office all the time, going to every trip and every conference known to man. That stuff starts to add up.

25:11 Stephen Brown

But most of the time, I think people have been a little bit more disciplined the last couple of years as things have got tight. But most of the time they've got too much payroll.

And sometimes that's just, we talked about earlier how there are just fixed costs you have to make and you haven't diluted those sufficiently with revenue. And that can be really hard. Is this the leanest you can make your payroll? And sometimes they're like, oh yeah. And it's like, hmm, okay, then you need to grow your top line.

25:49 Stephen Brown

But sometimes it's just they've gotten sloppy.

I do think one of the things the last couple of years with inflation, we've experienced this at LedgerGurus being a payroll heavy company, labor is expensive. It's a lot more expensive now than it was five, six years ago.

26:11 Stephen Brown

And so if you see your operating expenses creeping up, that payroll is usually the first area that I'm going to look at. What's going on with payroll, and how do we tighten that up?

26:18 Stacy Walker

Yeah, I love that. Do we have a lot of brands that need to ask themselves that question?

26:24 Stephen Brown

Probably. I mean, your fixed expenses.

When your variable expenses go up, so like tariffs go up and I can't change that, where do I create relief? What's in my fixed expenses? I either have to sell more with those fixed expenses, but short term it's like, what can I cut? How do I cut?

Well, we've seen a lot of software. Software is another category there. Do you need all the software that you think you need?

26:55 Stacy Walker

I see that a lot actually, Stephen.

I talk to a lot of founders that go down their tech stack and they have multiple programs that are doing the same thing, that maybe just this one program would do. And when I say, tell me the thought process around these three, when this one could do all that those three are doing. Oh well, we signed up for these three, and then we signed up for this one, and I guess we could let those others go, but we just haven't looked back at it to think about it.

I think that happens, right? You get in the weeds of running the business and you forget there are things out there that you could do to save money.

27:34 Stephen Brown

And there's a lot of, I would call it software elitism. Like, I need the very best version of this and the very best version of that. When you go get G Suite, go get Microsoft 365, you can wipe out a lot of your other products. And yeah, they're not the best, there are point products that are better.

I think in Shopify land you get a whole lot of add-ons, add-ons, add-ons.

27:57 Stacy Walker

So many add-ons in Shopify land.

27:59 Stephen Brown

And you have to really interrogate and say, are these moving the needle, or are they just sucking dollars out of my bottom line?

28:10 Stephen Brown

So to me the pecking order of more efficient operating expenses is lifestyle first.

I don't see a lot of this anymore, but the, we're going to go to every conference, we're going to bring food into the office because we've got to do that. All that stuff. It's like, no, you can do without. It's a job, people will be okay.

28:35 Stephen Brown

And then I would look at software. Payroll is painful to have to cut, but you can optimize it. You've got agencies, you've got offshoring. And sometimes it's just, are people actually doing their job? It's not just about how much you're paying them. Are they as effective as you think they are? Holding them accountable.

28:54 Stephen Brown

But I like to look at net operating margin separate from my profit margin, because it really tells me how much profit the business is generating. If I were to give it to somebody else and they had a different tax and or funding structure, what would be the profits that business generates?

29:07 Net profit margin and debt

Stephen Brown

And then that kind of leads to the last one, which is your bottom line profit.

So I don't push too many people on this, although I'm doing it more and more. I've seen people go out and get a huge SBA loan and they have a ton of debt to service. And by pushing those interest costs down into other expenses, and treating net operating margin and net profit margin separately, usually what I can see is, it's debt. It's usually interest.

29:47 Stephen Brown

Sometimes if you've made a lot of investments and you're doing a lot of depreciation, you might have no bottom line profitability. And that can be a good thing from a tax perspective, if it's the right cost, because depreciation is a non-cash transaction. You've already spent the money, you're now just realizing the expense.

But if that is a cash transaction, say like an interest payment, that's where I've seen a lot of brands get into trouble.

30:11 Stephen Brown

The nice thing about debt, let's say it's a fixed loan. I went out and I took an SBA loan to start a business and I've got these fixed payments. The bigger the business, the smaller those payments are as a percentage of income. So you've got to dilute your debt.

30:33 Stephen Brown

There are a couple of types I see out there. Sometimes I see startup costs or acquisition costs debt. A warehouse, I got a loan to start the business, I used it to get going and that's hanging around my neck.

And then there's more operating debt, usually that comes in the form of inventory, where I need to pay for my inventory that takes months to produce, import and sell.

30:59 Stephen Brown

And so that's the kind of debt that I like personally. The other debt is kind of a personal preference, but I feel like inventory debt can make sense.

The debt that I hate is any sort of lending or financing where it's like, I'm going to go fund marketing. It's like, that's marketing, sales funds marketing. If you don't have the cash, I don't know.

31:27 Stephen Brown

When it's not related to buying inventory or investing in the business, like capital expenditures, that's the kind of debt that makes me cringe a little bit, because it rarely has a good return on investment.

31:39 Stacy Walker

Do you think net profit margin hides stuff? Like, does it hide stuff that contribution margin maybe would make more obvious?

31:50 Stephen Brown

Well, a lot of your tax treatment. If you have a good tax accountant and a good tax strategy, you want that number to be zero. Which is why I like to break out any sort of tax treatment stuff into other expenses. Because then I can see, what were the operating profits of this business, and then do all my tax stuff.

And what's the result as an owner? I want my margin to be zero as much as I can, because I now have to pay money to the government.

32:17 Stephen Brown

Each one of these margins has a story to tell.

Now, if I'm a buyer, I'm going to be looking at, this is not a margin but it's tossed around a lot, EBITDA. Earnings before interest, tax, depreciation, and amortization. And the way that I like to do net operating income is I kind of turn that into an EBITDA calculation.

32:43 Stephen Brown

Now, there are some other expenses and income that can go there. So let's say I sublease a piece of property. I often don't want to put that into my top line revenue, I will put that in other income. It shouldn't be a big number, it's not core to the business. If somebody did buy the business, they'd be buying the business that is producing profits from selling product, not from subleasing.

33:09 Stephen Brown

So that's the kind of stuff that I like to see down in other income, other expenses. Owners, if you're doing tax related things, fancy tax related things like your kids, leasing a vehicle, it's nice to dump that down into other.

33:20 Stephen Brown

There's a concept called adjusted EBITDA, or when you're smaller, there's another concept called seller discretionary earnings. So those are the earnings that exclude those personal expenses that are tax legal but not core to running the business.

And so a smart seller will shove a lot of those things down into other expenses. And so if they see near zero profit margin but they have really good operating margins, to me that's like, cool, good job, you're running a really good playbook.

34:00 Stephen Brown

When you hide those non-operating expenses in your operating expenses, then it tells the wrong story.

And the story really matters when you go to sell your business, because people are going to want to know what's going on. What is it that they're buying, and what is it that they're not buying? So it's good to break those out early.

34:27 Stephen Brown

But the other thing it's good to break them out for is, it can tell you, is my business healthy?

If I have healthy operating margins and unhealthy profit margins, it could be one of a couple of reasons. I have too much debt, or I have a really great tax strategy. Good job.

34:37 Who actually learns this

Stacy Walker

Do you find that founders that you talk to cling to these assumptions about margins, and you have to help them unwind why they need to let go of some of these misconceptions?

34:51 Stephen Brown

No, I feel like the bigger issue is they haven't spent the time understanding what these concepts mean.

I feel like we're past the time where you can just be like, it's not my problem, it's my tax accountant's problem, it's my outsourced accountant's problem.

35:09 Stephen Brown

No, you need to understand these things, because they drive decisions. The smarter people understand these things and they make decisions using the data.

So I would say more often than not, they just haven't. And I get it, these are weird concepts. Until you've taken an accounting class it's like a foreign language, and people are like, what are you nerds talking about?

35:37 Stacy Walker

It's so true. A lot of our founders are creatives and they don't want to worry about that until they have to worry about it.

So do you think there's a point in your business journey where the margins need to be more important than they were in the past? Or do you think from the beginning this is something somebody should be watching all the time?

36:01 Stephen Brown

I think this is an advantage to those that learn and use this information to make better decisions.

I do think there's a point where, we've seen a lot of multi eight figure sellers that don't understand these things. It's shocking. I don't know how long that will continue with all the pressure that this industry has experienced.

36:21 Stephen Brown

I would say if you want to be a nine figure seller, you better do the work to learn what it is. I would be shocked to find a nine figure seller who doesn't understand these concepts. You're too big not to understand these things.

So I feel like as you're moving on that transition from multi seven figure seller to eight figure seller, you really need to be leveling up your understanding of these concepts and using them to make better decisions.

36:48 Stephen Brown

I do feel like by doing that, you're more likely to have profitable outcomes, grow profitably, understand the implications.

When you get bigger, you have a lot bigger payroll. If you're doing your own warehouse, your own manufacturing, you're investing in very expensive equipment. And there are cash flow implications that don't show up on the profit and loss, but there are also profit implications that do eventually make their way over there.

37:30 Stephen Brown

So I talk about tax treatment. There are a couple of types of tax treatment. There's the stuff you're stuffing onto your business to minimize your tax liability. But there are also capital investments. Those are large investments, they tend to have to go onto the balance sheet, and they come off on the profit and loss over time in the form of a depreciation expense.

38:02 Stephen Brown

Which is an opaque concept to somebody who doesn't really understand accounting. But essentially, let's say I spend a million dollars on a forklift, I don't know, that's probably too much. On a warehouse. A million dollars on a warehouse.

I take that expense and reduce my profit over time, by time period. I don't know what the years are, I'm not a tax accountant. But every year I can take a percentage of that cost that I spent and take it as an expense.

38:20 Stephen Brown

And so, one, you have to look at the cash implications. But there are underlying profit implications, so understanding both of those things is really important. And a lot of people don't.

My biggest thing is, ask your CFO, ask your accountant more often. Tell me what this means, help me understand this, and keep asking until you get it. Get on YouTube, watch some videos, we've got a lot of content that describes these things.

38:40 Stephen Brown

I was there at one point. I had an engineering degree. I talked to finance guys about deferred revenue and I was like, what in the world are you maniacs doing? This is stupid. You guys come up with this weird way of tracking money.

Because I was good at tracking money as a consumer, but I didn't really understand accrual-based accounting. And when you, the first time you encounter accrual-based accounting, it just feels really wrong. It feels stupid. And then once you dig in and learn it, you're like, oh yeah, that actually makes a lot of sense.

39:11 Stephen Brown

Let me come back to you. You talk to our customers not only at the beginning of their journey with us, but also as they're going on. Do you see changes? Do you see patterns of education that they experience over time?

39:29 Stacy Walker

Yeah, I've been thinking about that while we've been having this discussion.

Because the ones that want to be successful, the ones that want to improve, the ones that want to build really solid brands, are the ones that are using their financials as their decision making tool. And they're not the ones that call the bank every day to see what their balance is. They're not the ones that are like, well, I think I could probably buy that warehouse because I have $200,000 in the bank and I could get a loan for the rest of it.

40:07 Stacy Walker

The biggest difference I see, Stephen, is, are your financials your decision-making tool, or are they your compliance task?

And if they're a compliance task, I can almost promise within a certain amount of time that they'll fail, if they don't have some kind of a flip that causes them to decide they want to start making it a decision-making tool.

40:23 Stacy Walker

And we see this all the time. I can almost guess from the sales process if a customer is going to be successful, just by how responsive they are, how much they know about their business during our conversation, and how much they want to know more. If they don't care, then I can almost promise that it won't go anywhere.

40:43 Stephen Brown

Well, and I like that last one. How much do they want to know? They don't have to understand these things, but do they want to understand these things?

40:48 Stacy Walker

Hey, Stephen, why do sellers so often think they're profitable, but they're still running out of cash?

40:56 Stephen Brown

So good accrual based accounting is looking at the timing of things. When were things sold, not when the cash came in or out of the business.

And so because of that, you have issues with revenue timing. Cost of goods sold done right does not reflect when the inventory was purchased, it reflects when the inventory was sold.

41:26 Stephen Brown

And the reason you want to do that is, I've done a webinar on this before, but if you're trying to track profitability, it's all over the place. I don't know how profitable I really am. And so you want to do accrual based accounting because it actually tells you where you are profitable in that time period.

But underneath that, I might have to go buy a boatload of inventory for the next holiday season. And that far exceeds the profits you're going to earn in that period.

41:44 Stephen Brown

So this gets more into the balance sheet. But if done right, you'd be like, good profits, no cash. I'd immediately be like, what's your inventory balance? I've got $2 million in inventory sitting there. I'm like, well, there's your profits. They immediately got gobbled up, plus some, into inventory.

So that's usually why. I would say these businesses are profit rich, cash poor.

42:05 What to fix first

Stacy Walker

Yep, I totally agree.

So if we have sellers that are listening right now and they're thinking, man, I just wish I could fix one thing this quarter, which margin would you tell them to fix?

42:20 Stephen Brown

In today's environment, I would probably say you've got to scrutinize your fixed expenses.

Because cost of goods sold, we've probably seen go up this last year, really hard to improve, takes months to quarters to years. Contribution margin, same thing. Changing a 3PL can take months to quarters. Improving your advertising can take a long time.

42:50 Stephen Brown

Fixed expenses, you can tackle those right away. It's really easy to cut costs. It's not fun, it can be painful, but you can do it quickly. Go down the list. Am I using it? Is there something I'm already using? Is there a cheaper alternative? You can cut costs immediately. That's the most immediate thing you can improve.

43:03 Stephen Brown

But the longer answer is you should really be watching all of those things and managing all of them. Like I said, some are easier to change, some take longer to change. But you've got to keep your eye on them, because if you don't, costs will creep up. It's like financial entropy. It's going to try and sneak out of your business, so you've got to keep your eyes on it so it doesn't.

43:29 Stacy Walker

Yep, that's so true.

So what do you think is the simplest dashboard or metric set that you recommend to sellers, so they can stop guessing and start managing?

43:39 Stephen Brown

Well, this is a good preview for our next episode, where we're going to get into KPIs and metrics.

A lot of the ones I've mentioned here. The most basic things I like to track are what's going on with revenue, fulfillment, advertising, bottom line. And then I like to keep my eye on cash. If those were my six, if there were six things I'm going to track, I'd start there.

Now in reality, I like to track about 20 different things, a lot more on the profit and loss, and then more on the balance sheet and cash flow. But those are the ones that I'd keep my eyes on.

44:13 Stacy Walker

But those are the ones you'd start with. Okay, I love that.

44:18 Stephen Brown

Let me ask you one or two wrap up questions.

If there's one thing you could tell the industry to do differently, based on, you probably talk to more brands than anybody, what would you tell them?

44:27 Stacy Walker

The one thing, get your COGS under control. Get your COGS under control. Inventory has to be under control. It's your biggest asset. Why wouldn't you want it under control?

Get it under control. Do what it takes to get it done. It's hard work. And when you're muddling through it, you're going to want to shake your fist and say, why did I even start this? But on the other side of it, when you come out of it, you're going to wonder why you didn't do it sooner.

44:29 Stephen Brown

Awesome. All right, for those of you that have stuck with us to the end, hopefully your knowledge has gone up a bit, and we'll see you on the next episode.