Summary
Stephen Brown, COO at LedgerGurus and host of the Ecommerce Finance Podcast, sits down with Stacy Walker, Director of Growth at LedgerGurus. They break down the four margins every ecommerce brand should be tracking and why most 7- and 8-figure sellers only understand one of them. The conversation focuses on why founders feel profitable but still struggle with cash and confidence in their numbers.
This episode explains gross margin, contribution margin, net operating margin, and net profit margin in plain language. Stephen and Stacy walk through what each margin actually tells you, where brands get them wrong, and how bad data hides real problems. Listeners walk away knowing which margin points to pricing issues, ad efficiency problems, or bloated overhead.
Takeaways
- Gross margin isolates product and inventory costs, so you can see pricing and supply chain pressure early.
- Bad inventory data makes gross margin look fine, while profit quietly erodes.
- Contribution margin shows what is left after selling costs and determines how much room you have to operate.
- Low contribution margin leaves no buffer for payroll, software, or growth mistakes.
- Advertising efficiency is often the biggest driver of contribution margin swings.
- Net operating margin reveals whether overhead is sustainable as the business grows.
- Payroll is usually the largest hidden drain on operating margin.
- Net profit margin can hide problems when debt, taxes, or owner expenses are mixed into operations.
What We Cover:
00:00 Understanding Financial Margins in Ecommerce
02:41 The Importance of Accurate Profitability Tracking
05:36 Gross Margin: Definition and Common Misunderstandings
08:16 The Impact of Cost of Goods Sold on Profitability
10:55 Inventory Management and Its Financial Implications
13:48 Contribution Margin: What It Is and Why It Matters
16:38 Balancing Gross and Contribution Margins
19:26 The Role of Advertising in Contribution Margin
22:16 Operational Efficiency and Financial Health
25:44 Understanding Net Operating Margin
33:15 The Importance of Debt Management
39:10 Decoding Profit Margins
46:45 Cash Flow vs. Profitability
48:27 Scrutinizing Fixed Expenses
50:46 Final Thoughts on COGS Management
Guest Information
Stacy Walker is the driving force behind LedgerGurus’ world-class sales and marketing team. With a background in retail banking focused on business relationships and lending, she brings a deep understanding of how financial insights can empower business owners to make smarter decisions. Passionate about helping entrepreneurs see their numbers as more than just reports, Stacy works to connect financial clarity with business growth.
When she’s not leading her team or talking to ecommerce sellers, you’ll find her hiking with her family, baking something sweet, or tending to her ever-expanding flower garden; usually with dirt on her hands and a new gardening book nearby.
Work with LedgerGurus
If you want clarity on which margin is actually hurting your business, our CFO advisory team helps ecommerce founders turn messy numbers into clear decisions.
Transcript
Stephen Brown (00:00)
There are four financial margins I like to watch, but too many seven and eight figure brands only looking at one or two, and those are often inaccurate. I’m Stephen Brown, host of this, 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 gonna 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.
Stacy Walker (00:27)
Thanks for having me, Stephen. I’m excited to visit with you today about margins and how our customers and prospects can learn more.
Stephen Brown (00:35)
How many brands do you usually talk to in a given week?
Stacy Walker (00:39)
I would say between 8 and 15 depending on the week.
Stephen Brown (00:42)
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?
Stacy Walker (00:52)
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’s different margins that they should be tracking or why they would even care about different ones.
Stephen Brown (01:07)
So what are the questions they have about profitability when they come? And usually the first person they talk to. What questions do they have around the profitability?
Stacy Walker (01:13)
Yeah.
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.
Stephen Brown (01:33)
we do that, I want to kind of dig a little bit deeper in 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 profitability, their bottom line profitability?
Stacy Walker (01:47)
20 % of the time. Almost never, yeah.
Stephen Brown (01:49)
20 % of the time.
So, okay, let’s kind of go down. We’ll introduce the four So, 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. 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?
Stacy Walker (02:16)
Oh, they almost never have accurate gross margin. Um, calculations almost never. I would say 10%, 10 % and they just don’t know. They just don’t know.
Stephen Brown (02:19)
I would agree.
10%. 10%. I think that’s generous.
Would you say 10 % are accurate or 10 % know what it is?
Stacy Walker (02:32)
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.
Stephen Brown (02:39)
I think it’s lower than that because I’ve, yeah, I’ve talked to lot of customers and they confuse gross margins 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. If you want to look at it as a how often would you say people understand the concept of contribution margin?
Stacy Walker (02:40)
do you?
Hmm. I can see that. Yeah.
Nobody ever understands the concept of contribution margin or they think contribution margin is gross margin. Yeah.
Stephen Brown (03:07)
I would 100 separate degree. Correct. I would
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. So let’s talk about the four margins
Stacy Walker (03:21)
Yeah.
Stephen Brown (03:25)
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. 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 land and product costs and the costs of the goods sold. But I see a lot of people stuffing merchant fees. I see a lot of people putting fulfillment costs into the cost of sold. And that SKUs…
Stacy Walker (03:56)
Yep. Ad spend because
they think that what costs it, that’s part of selling it. They wouldn’t be selling it for ads. Yeah.
Stephen Brown (04:01)
Sometimes they do add spend as
of
this comes from whoever set up profit and loss statements, nerd accountant powers that be. There’s cost of sales section or 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.
Stacy Walker (04:15)
That’s true.
Yeah.
Stephen Brown (04:23)
Now, run a lot of people that want a better understanding of their gross margins, right?
Stacy Walker (04:27)
Yeah, they do. They do. 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, why do you think that is Stephen? Why do you think margins are so like such a huge misunderstood area for ecommerce sellers?
Stephen Brown (04:34)
Okay, so what do they ask? Why do…
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. the reason I am a non-accountant, I’m a dumb MBA, but I do CFO work. I guess I’m not so dumb. The reason I think 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 margins, that percentage of
Stacy Walker (04:46)
That’s fair.
Stephen Brown (05:08)
of income. So how, what percentage of income is your cost of goods sold? And the 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 margin divided by the income, that’s my gross margin. That want to track in isolation because it really tells me what’s going on with product costs. And product costs, we look at our, you know, 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’s different ways you come up with that. the reason you wanna track that differently, and I think the last couple of years really been illustrative on this point, cost of goods should stay fairly static 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 if I look at it on a chart, it’s kind of a flat line. But the last couple years, we’ve seen supply chain issues. seen so that importing cost goes up, get big spikes.
Stacy Walker (06:06)
Yeah,
Stephen Brown (06:17)
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 to the bottom at your profit level. And so when I think about that, like, well, what can I do to improve my…
Stacy Walker (06:26)
Absolutely.
Stephen Brown (06:43)
If my cost of sold is going up, what are my options? Well, I can negotiate better terms of suppliers. big one is adjusting pricing. I can try and re-engineer my supply chain. But I think for many, many years, decades, we’ve seen these underlying costs be fairly and therefore haven’t had to worry about them.
But, now we do, and if you’re not tracking, 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.
Stacy Walker (07:16)
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, where’s my money going? Why do I have, why do I think I’m making more than I’ve ever made, but I have less, less cash in the bank than I’ve ever had.
Stephen Brown (07:33)
Yeah, well, 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 You’re like, where’s my cash? Well, it gets tied up in inventory, which gets related to cost of sold. This is one of the biggest problems I think we’ve ran into good cost of goods sold in inventory accounting is based on good
Stacy Walker (07:38)
Yep, exactly.
Stephen Brown (07:57)
inventory management and a lot of people don’t do a good job with that. And so you get a lot of leakage.
Stacy Walker (08:02)
Yeah. Or yeah.
And, you, I see this every day. People don’t 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, off the charts compared to say last, even last quarter, even last year.
Stephen Brown (08:14)
Mm-hmm.
Stacy Walker (08:30)
and they don’t realize until it’s been a hot second.
Stephen Brown (08:33)
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 cost profit leakage from cost of goods sold problems. So that would include things like damaged inventory. you brought in a bunch of inventory, somebody
back to a forklift in your box and boom, that wasn’t tracked. There is theft. I don’t care whether you have your own warehouse using the 3PL, people could swipe some goods. ⁓ If you have expiration date on your inventory, it could expire. There is lost inventory. And a lot of that, all that comes back to inventory management.
And we oftentimes will capture those issues when we do, we work with a customer who really gets serious about inventory, say let’s do an inventory count, they do a count, 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 well we’ve been chasing.
Stacy Walker (09:40)
Yep.
Stephen Brown (09:45)
with our customers for years, because it’s really hard, but it’s so important to do because you’re losing profit and or you’re losing signals that, well, there’s two things. The things we started talking about is those are things you can take action on with pricing, with vendor relationships, supplier relationships. The latter is operational stuff that might not be a big number, but over time as it adds up, you know,
Stacy Walker (09:45)
I totally agree. Yeah.
Definitely.
Stephen Brown (10:08)
percent here, percent there really can become a big problem.
Stacy Walker (10:11)
Yeah. Didn’t you tell me that your ecommerce brand, that your 3PL let you know that they found like what a whole pallet of stuff that they, that had been lost in the warehouse.
Stephen Brown (10:22)
Yeah, we bought the business and then they said, oh, we found a pallet and it’s 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. And I’ve been to the warehouse and it I don’t know, I’ve been to a handful of warehouses and I’m always you kind of expect them to be really cool, like you see on videos like Amazon. They’re not, you know? And I’m sure Amazon, I mean, Amazon loses damages inventory. I mean, there’s a whole…
Stacy Walker (10:31)
Yeah.
Yeah, yeah. There now.
yeah.
Stephen Brown (10:49)
whole industry there that helps get refunds on that. It’s just the reality of warehouses, but you know, stuff happens. And I think whether you’re doing it, managing it yourself, or you’re using a 3PL, you need to keep your eyes on that and understand if there’s leakage, that why. I mean, I’ll give you a good story from a couple years ago, we had a customer that hadn’t done a count in years, we had told them.
guys really needed to do a count really needed 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, ⁓ your value on the books is very different than what you have in the warehouse. 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, 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.
Stacy Walker (11:29)
⁓ wow.
Yeah.
Yeah.
Stephen Brown (11:43)
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. There’s 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. Like are you losing one, two, three points of profit?
Stacy Walker (11:51)
Yeah.
Stephen Brown (12:11)
due to sloppy operations. And that’s where the gross margin tracking that can uncover that, if it’s done right, which is really hard to do. I mean, what are customers, when they’re talking about inventory, accounting, and gross margins with you, you’re at the tip of the sphere, what are some of the questions they’re asking? What are some of the, I mean, it sounds like they sense there’s a problem, but like, is their initial understanding?
Stacy Walker (12:13)
Yeah. Yeah.
Yeah, I agree. I think it is hard to do.
Yeah.
Yeah, they definitely sense there’s a problem and there’s definitely frustration around 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 take a business that sells three widgets. 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.
Stephen Brown (12:50)
Mm-hmm.
Stacy Walker (13:03)
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’s just too many, there’s too many touch points where human error could come into place. And like, think about it, one transposition of the numbers and you could be totally off the rails and not know it.
Stephen Brown (13:24)
And when you start dealing with suppliers, you got multiple orders coming in. just, but yeah, talk about the next margin, contribution margin. This is something that nobody, feel like nobody in seven and eight figure ecommerce land really understands. And, but they really should.
Stacy Walker (13:29)
multiple sales channels, it escalates so quickly.
Some of them don’t even know what it is. You don’t know how many people, like 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.
Stephen Brown (13:47)
Well, let’s talk.
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. Now, the debate I would say, 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.
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. And so,
Stacy Walker (14:38)
I totally agree. That’s exactly what
I was going to say.
Stephen Brown (14:41)
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, my, if you think about it, these two ratios, they tend to be fairly consistent as a percentage of sale. 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, know, fulfillment, let’s say fulfillment’s % processing fees is usually about 3%, so that’s 13. Advertising’s all over the place. That’s where the argument could keep it out. The other two tend to be fairly to month or on average.
But advertising, I’ve seen it range from 20 to 35 % or more of sale. And so after, let’s add that up. Let’s just take a round number, 30 % plus plus 43. And 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.
And unusual to see that, but basically what that tells me is what’s left over. Every time I sell, I don’t how many units of widgets I sell, I’m only gonna be left over with a certain percentage of that sale 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.
Stacy Walker (16:15)
So you say if you have a really low one, what do you think is an ideal contribution margin for an ecommerce brand?
Stephen Brown (16:21)
we should back it up. What do you think an ideal gross margin is?
Stacy Walker (16:24)
oooo
50%.
Stephen Brown (16:26)
I think it varies, heard, so the answer is it depends, you’re looking at getting lending, a lot of people want gross margins at minimum of 40%. So that means your cost of goods sold is 60%. Now that is really hard to run a consumer products brand 40 % gross margins. The ones I see that are lower gross margin tend to be resellers. Somebody that’s
Stacy Walker (16:38)
Okay. Okay.
Mm,
Stephen Brown (16:51)
selling
Stacy Walker (16:51)
okay.
Stephen Brown (16:52)
a product that’s not theirs, that’s, you know, like M &Ms or, you know, unbranded, somebody else’s brand. Because the challenge with that is there’s a lot of other people out there selling your ability to sell, your pricing power is almost zero because the manufacturer’s gonna give you the manufacturer’s suggested retail price competition.
Stacy Walker (16:54)
Yeah.
Yeah.
Stephen Brown (17:16)
know, the prices tend to normalize when you’re reselling product. That’s why you get big gross, like I think Costco has a really low, a really low gross margin, but they make it up with volume. If you’re a small seller, you don’t have that capability. you’re a direct to consumer brand, your gross margins really need to be closer to like 70, if they’re not,
Stacy Walker (17:20)
Yeah, I think that’s true.
I think that’s true, yeah.
Stephen Brown (17:40)
you don’t have enough dollars left over to capture Like if I’m selling a known good, I can do SEO and do demand capture for less cost. But if I’m have some like the product we have, Sole Toscana, skincare, I’ve got to make people aware of that product and help them understand why they need to do that. So I have to spend more on advertising.
Stacy Walker (17:49)
Yeah.
Stephen Brown (18:01)
Either way, are these, so let’s go down to contribution margin. Well, 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.
Stacy Walker (18:12)
You need to spend more.
Okay.
Stephen Brown (18:16)
I think the best contribution margins I’ve seen are around 40%. I would say 20 to… say 20 to 30 is not uncommon.
Stacy Walker (18:21)
wow, that high, that’s good. Okay.
What do you consider healthy though? What you’re seeing may not be what you consider to be the healthy margin.
Stephen Brown (18:34)
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 like a base level investment you need to run the company. If you think about it, like
you can take the creative, 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. I’m trying to think of another back, kind of back office. Let’s say you have like an R and D team that’s doing product development. Well,
Stacy Walker (19:08)
Yeah.
Stephen Brown (19:19)
the cost of building, designing a, I’m just trying to think, like a phone case, I got my phone here. The design cost is gonna be essentially the same, regardless of how much you sell. ⁓ So I think the challenge you run into with contribution margin is you’re smaller, you need more contribution margin to support that fixed cost. But as you scale, fixed costs should,
Stacy Walker (19:29)
That’s true, yeah.
Stephen Brown (19:43)
get smaller as a percentage of income because you don’t need to scale those with the growth of your business.
Stacy Walker (19:50)
Stephen, do you think there’s ever a point where contribution margin becomes more important than gross margin?
Stephen Brown (19:56)
No, because they each telling you different things. margin, if my gross margin down, I want to dig in and see what’s going on. Is it more tariffs? it underlying manufacturing costs are going up? Do I have leakage or inventory management issues? If my contribution margin down, but my gross margin does not, then I want to dig into those cost of sales. did I have my fulfillment costs gone up for some reason?
have my, you’re including advertising into your cost of sale, which I like to, that’s the most likely culprit is advertising efficiency deteriorates. I’m watching those things because they tell me different, they’re gonna tell me different things.
Stacy Walker (20:34)
When you talk to, you do a lot of our advisory. So when you talk to some of our brands that you’re working with, are they ever surprised to learn about contribution margin and like the critical role it plays in their financials and the health of their business?
Stephen Brown (20:38)
Correct.
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, which is, you it’s not on the P &L, so I have to do some reporting or I do some dashboarding show them. And it’s confusing, right? They’re like, I don’t get this concept. those that do and are watching
Stacy Walker (20:54)
Okay.
And it’s not on the PNL.
Yeah.
Stephen Brown (21:13)
you know, they’re at another level. A lot of times what I see, let’s kind of take it back it up with gross margins. I can see pretty quickly gross margins aren’t being calculated accurately. And I graph it and it’s not somewhat flat in nature, then like, okay, do we have some underlying cost increases? Like last year, you know, let’s talk, I’ll ask about tariffs.
Stacy Walker (21:23)
What’s your trigger? What tells you that?
Okay.
Stephen Brown (21:37)
A lot of people understand their input costs somewhat well. Did tariffs affect you? But if the answer was no, or we adjusted it’s not flat, then usually have to dig in for a multi-month or longer effort to help them up their processes. But we can help them on the accounting front. We can’t help them on the operational front, like you said.
Stacy Walker (21:56)
That’s true.
Stephen Brown (21:57)
So when it comes to contribution margin, I think it’s more like, that’s interesting, what do I do with it? And what do 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 is I think debatable why you should or shouldn’t, advertising is hard to maintain a consistent efficiency.
There’s times a year where you can get a lot of bang for your buck and there’s times a year where you’re really investing. And so that’s an argument for having contribution margin not include advertising 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
Stacy Walker (22:18)
Yeah.
Yeah.
Stephen Brown (22:43)
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 wrong. Something’s not working. Yeah.
Stacy Walker (22:50)
Yeah.
Okay. Okay.
Should we talk about net margin?
Stephen Brown (22:55)
Let’s talk about net operating margin. This is one that most people don’t do because they don’t, a lot of people say, well, you know, if I don’t have this conversation too often, but I typically like to take.
Stacy Walker (22:57)
Okay.
Stephen Brown (23:07)
non expenses and put them down into other expenses and income into other income. the net operating me how efficient the business So things that I like to put in those other things like interest, I like to put push interest down into other expense. Why? That is not of how effective the business is. That is a measure of how
effective your capitalization of the businesses. 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,
Stacy Walker (23:35)
Yeah, yeah.
I can see that.
Stephen Brown (23:54)
turn mine into an EBITDA, earnings before interest tax depreciation and amortization. So all the it does stuff, like to push down on other expense. So then I can see what the underlying efficiency of the business is. 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.
Stacy Walker (24:24)
Yeah.
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.
Stephen Brown (24:34)
Yeah, to a certain extent it is. If I add all these these operating components. Let’s say I have a really good contribution margin 40%. But my net operating margin is like tells me I got a lot of overhead.
Now, there’s a couple of reasons why you may have a lot of overhead, but there’s one in particular that is the most common culprit.
Stacy Walker (24:56)
What is it?
Stephen Brown (24:57)
payroll.
Stacy Walker (24:58)
Hmm, okay.
Stephen Brown (24:59)
That’s usually the biggest operating expense. Now sometimes, sometimes I see people that have too much rent. I used to see, not as much in the last couple years, but there used to be a lot of lifestyle stuff going on. You’d lunch in the office all the time, going to every trip and every conference known to man. stuff starts to add up, but most of the time, you know, I think people have been a little bit more disciplined the last couple of years if things have got tight.
Stacy Walker (25:11)
Yeah.
Stephen Brown (25:25)
but most of the time they got too much payroll. And sometimes that’s just a, we talked about earlier how is just fixed costs you have to make and you haven’t diluted those sufficiently 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. But.
Stacy Walker (25:38)
Yeah.
Stephen Brown (25:49)
Sometimes it’s just, you know, 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 company. Labor is expensive. It’s a lot more expensive now than it was five years ago, five, six years ago. And so if you see your operating expenses creeping up,
Stacy Walker (26:01)
Yeah, yeah, so expensive.
Stephen Brown (26:11)
You know, that payroll is usually the first area that I’m going to look at is what’s going on with payroll and how do we tighten that up.
Stacy Walker (26:18)
Yeah, I love that. I love that. Do we have a lot of brands that need to ask themselves that question?
Stephen Brown (26:24)
Probably, you know, I don’t know. mean your fixed expenses
I think with 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? So how do I cut? Well, we’ve seen a lot of software. you know, software is another category there. There’s a lot is like, can you, you know,
Do you need all the software that you need to, that you think you’re spending So I would just, yeah.
Stacy Walker (26:55)
I see that a lot actually, Stephen. I
talked to a lot of founders that have, that they go down their tech stack and they have a multiple things that multiple programs that are doing the same thing that maybe just this one program would would do. And when I say, tell me, like, 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’s things out there that you could do to save money.
Stephen Brown (27:34)
And there’s a lot of, I would call it software elitism like, I need the very best version of this and very best version of that when it’s uh, you go get G suite, go get Microsoft 365. You can wipe out a lot of your back products and yeah, they’re not the best that, know, there’s point products that are better. I think in Shopify land, you get a whole lot of add-ons, add-ons, add-ons and
Stacy Walker (27:57)
So many add-ons in Shopify land.
Stephen Brown (27:59)
And you have to really interrogate and say like, are these moving the needle or are they just sucking dollars out of my bottom line?
Stacy Walker (28:08)
Yeah. Yeah.
Stephen Brown (28:10)
So to me, the pecking order of more efficient operating expenses is lifestyle first.
If you’re in, I don’t see a lot of this anymore, but the, we’re to go to every conference. We’re going to bring food into the office because we got to do that. All that, all that stuff. It’s like, no, you can, it’s a job. People, people will be okay. then I would look at like software. Payroll can be very, it’s painful to, have to cut, but you can optimize it and you’ve got.
Stacy Walker (28:28)
do without. Yeah.
Stephen Brown (28:42)
Agencies, you’ve got offshoring, you’ve got, sometimes it’s just like, 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? But I like to look at net offering margin separate from my profit margin because really tells me how much profit the business is generating
Stacy Walker (28:54)
Yeah, yeah.
Yeah.
Stephen Brown (29:07)
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?
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, they’ll go out, they’ll get a huge SBA loan and they have a ton of debt to service. And by pushing that those interest payments costs down into other expenses and treating net offering margin and
Stacy Walker (29:16)
Yeah.
Yeah.
Stephen Brown (29:39)
net profit margin Usually I can see is are
it’s debt. It’s usually interest. Sometimes if you have some, you’ve made a lot of investments and you’re doing a lot of depreciations, 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 really realizing the expense. But if that is a cash transaction, say like an interest payment,
Stacy Walker (29:47)
Yeah.
Yeah.
Stephen Brown (30:11)
That’s where I’ve seen a lot of brands get into trouble. And it’s like, well, the nice thing about debt, on the debt, let’s say it’s a fixed loan. 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. they, it’s like, you got to dilute your debt. So there’s a couple of types I see out there. I see,
Stacy Walker (30:27)
That’s true.
Stephen Brown (30:33)
I see typically, sometimes I see like startup costs or acquisition costs debt. a warehouse, I funded, got a loan to start the business and I, and I’m using that. got used to get going and that’s around my head. And then there’s, there’s more operating debt usually that comes in the form of inventory where I’m like, I need need to pay for my inventory that takes months to produce import.
Stacy Walker (30:52)
Yeah. Yeah.
Stephen Brown (30:59)
and sell. And so that’s the kind of debt that I like personally. The other debt is, I don’t know, it’s 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, sells funds marketing, right? If you don’t have the cash, I don’t know, that’s the kind of stuff.
Stacy Walker (31:18)
Yeah, I agree with you on that.
Yeah.
Stephen Brown (31:27)
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 kind of cringe a little bit because it rarely has a good return on investment.
Stacy Walker (31:39)
Yeah. Yeah. Do you think net profit margin, ⁓ hides stuff? Like, it hide stuff that contribution margin maybe would make more obvious?
Stephen Brown (31:50)
Well, yeah, a lot of your tax treatment, if you have a good tax account and a good tax strategy, yeah, want that, you want that, that number to be zero, which is why I like to break out like any sort of tax treatment stuff into other expenses, because then I can see what was the, what was the operating profits of this business and then do all my tax stuff. And what’s the results as a owner? want my margin to be zero as much as I can.
because I now have to pay money to the government. 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 net operating income is I kind of turn that into EBITDA calculation.
Stacy Walker (32:17)
Yeah.
Yeah.
Yeah.
Stephen Brown (32:43)
Now there’s, are some other expenses and, income that can go there. So sometimes you, let’s say I sublease a piece of property. 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. So that’s the kind of stuff that.
Stacy Walker (32:57)
Yeah.
not from the other. Yeah.
Stephen Brown (33:09)
that I like to see down another 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 There’s a concept called adjusted EBITDA or when you’re smaller, there’s another concept called seller discretionary earnings. So that are the earnings.
Stacy Walker (33:20)
Yeah.
Stephen Brown (33:33)
that exclude those personal expenses that tax legal, but not core to running the business. And so a smart seller will do a lot of those things and shove a lot of those things down other, or they should shove them down to other expenses. And so if they see near zero profit margin, but they have really margins, to me that’s like cool.
Stacy Walker (33:42)
Yeah.
Stephen Brown (34:00)
Good job, you’re running a really good playbook. when you hide those non-operating expenses in your operating expenses, then it tells the wrong story.
Stacy Walker (34:00)
Yeah.
Yeah.
Stephen Brown (34:10)
And the story might
not matter, know, 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 kind of break those out early. But the other thing it’s good to break them out for is can tell is my business healthy. If I have healthy operating margins and profit margins, could be one of a couple of reasons. I have too much debt.
Stacy Walker (34:27)
Yeah.
Stephen Brown (34:34)
or have a really great tax strategy. Good job.
Stacy Walker (34:37)
Do you find that ⁓ founders that you talk to kind of cling to these assumptions about margins and have to kind of help them unwind why they need to let go of some of these misconceptions that they have?
Stephen Brown (34:51)
No, I feel like the bigger issue is they spent the time understanding what these concepts mean.
Stacy Walker (34:57)
I agree.
Stephen Brown (34:58)
I feel like we’re past the time where you can just be like, it’s not my problem, it’s my tax account, it’s problem, it’s my, you know.
outsourced accountants problem. 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, it’s, they just haven’t, I get it, these are weird concepts. Like until you’ve taken an accounting class, just, it’s like a foreign language and people are like, what are you nerds talking about?
Stacy Walker (35:09)
You have to understand your business.
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, right? 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?
Stephen Brown (35:37)
Mm-hmm. No.
I think this is an advantage to those that in, learn and use this information to make better decisions. I do think there’s a point where think 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. I would say if you want to be a nine figure seller, you better
Stacy Walker (36:01)
Yeah.
Yeah.
Stephen Brown (36:21)
you know, 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 to understand things. So I feel like as you’re moving on that transition from seven figure, multi seven figure seller eight figure seller, you really need to be leveling up your understanding of these concepts and using them to make better decisions. I do feel like by doing that,
Stacy Walker (36:31)
Yeah.
Yeah.
Stephen Brown (36:48)
you will, you’re more likely to have profitable outcomes, grow profitably, understand the implications of I mean, when you’re looking at, you get bigger, have lot of times a lot bigger payroll. If you’re doing your own warehouse, your own manufacturing, you’re investing in very expensive equipment. And there’s cashflow that don’t show up on the profit and loss, but there’s also, are,
profit implications that do eventually make their way over there. So you do wanna see, you know, I talk about tax treatment. There’s a couple types of tax treatment. There’s the stuff you’re stuffing onto your business to minimize your tax liability. But there’s also capital investments. Those are large investments 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, which is opaque concept to somebody who doesn’t really understand accounting. But essentially, let’s say I spend a million dollars a forklift, I don’t know, that’s probably too much, on a warehouse, right? A million dollars on a warehouse. 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.
Stacy Walker (38:02)
Yeah.
Stephen Brown (38:02)
Every
year I can take a percentage of that cost that I spent and it as an expense. And so, one, you have to look at the cash implications, but there is underlying profit so, understanding both of those things is really important, but a lot of people don’t. My biggest thing is ask your…
Ask your CFO, ask your accountant more often. Tell me what this understands. 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. 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
Stacy Walker (38:29)
Yeah.
What in the world? ⁓
Stephen Brown (38:52)
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, just feels really wrong. It feels stupid. And then once you dig in and learn it, you’re like, ⁓ yeah, that actually makes a lot of sense.
Stacy Walker (38:58)
Yeah.
Ha
Yeah, yeah. ⁓
Stephen Brown (39:11)
Let me come back
to you.
And you talked to our customers not only at the beginning of their journey with us, but also as they’re going on. Do you find, do you see changes? Do you see patterns that of education that they experience over time?
Stacy Walker (39:29)
Yeah, I’ve been thinking about that while we’ve been having this discussion. ⁓ because, because I do 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. Right. 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. the biggest difference I see Stephen is that are your financials, your decision-making tool or are they your compliance task? And if, and they’re compliance task, 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.
Stephen Brown (40:07)
Hmm.
Stacy Walker (40:23)
And we see this, we see this all the time. I can, 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 can almost promise that it won’t go anywhere.
Stephen Brown (40:43)
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?
Stacy Walker (40:48)
Yeah,
yeah.
Hey, Stephen, why do sellers so often think they’re profitable, but they’re still running out of cash?
Stephen Brown (40:56)
So good accrual based accounting is looking at the timing of things when, when were things sold, know, not when the cash came or out of the business. And so because of that, have issues with revenue timing. You have issue, cost of goods sold done right. Does not reflect when the inventory purchased. It was reflects when the inventory was sold. And so because of that,
And the reason you want to do that is like, I’ve done a webinar on this before, but like if you’re trying to track profitability, it’s all over the place. Like, I don’t know how profitable I really am. And so you want to do a cruel based accounting because it actually tells you where you are profitable in that time period. But under beneath that, I might, I gotta 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.
Stacy Walker (41:26)
all over the place.
Stephen Brown (41:44)
So this gets more into the balance sheet, but if done right, you’d be like, good profits, no cash. I’m 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, know, I would say these businesses are rich cash for.
Stacy Walker (42:05)
Yep. Yep. I totally agree. ⁓ okay. So if we have sellers that are listening right now and they’re thinking, man, I just, I wish I could fix one thing this quarter. Which one would you tell that? Which margin would you tell them to fix?
Stephen Brown (42:20)
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. Fixed expenses, you can tackle those right away. It’s really easy to cut costs. It’s not fun.
Stacy Walker (42:49)
Yeah.
Stephen Brown (42:50)
can be painful, but
Stacy Walker (42:51)
Yeah.
Stephen Brown (42:51)
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. But the longer answer is you should really be watching all of those things and managing all of them, right? Like I said, some are easier to change.
Stacy Walker (43:03)
Yeah, I love that.
Stephen Brown (43:14)
Some take longer to change, you gotta keep your eye on them because if you don’t, costs will creep up. It’s just, it’s like financial entropy. gonna try and sneak out of your business, so you gotta keep your eyes on it so it doesn’t.
Stacy Walker (43:29)
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?
Stephen Brown (43:39)
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. then I like to keep my own cash. If that was my six, if I was, there are six things I’m going to track, I’d start 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 my eyes on. Yeah.
Stacy Walker (44:13)
But those are the ones you’d start with. Okay.
Okay. I love that.
Stephen Brown (44:18)
Let me ask you one or two wrap up questions. there’s one thing you could ask, tell the industry to do differently based on all, you probably talked to more brands than anybody. What would you tell them?
Stacy Walker (44:27)
The one thing, get your COGS under control. Get your COGS under control. Inventory has to be under control. It’s your biggest asset. Like 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 like 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.
Stephen Brown (44:29)
Well, get your COGS under control. Your inventory.
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.