Finance for Product Managers — calculating profit and loss for a simple online business
This is the first post in a proposed series exploring the financial aspects of managing a digital product. Let’s imagine a really simple online business and ask the fundamental question — will it make any money?
Suppose we spot some cute toy cars available as a job lot from an overseas supplier. We can get 1000 cars for $1000, including shipping and any import duty. That’s $1 per toy. The business idea is to buy them, open a pop-up online store that will operate for one month in the run-up to Christmas, and sell the cars in our local market for $5 each. How much money could this make?
We need to estimate our likely profit and loss. In accounting ‘P&L’ is reported in an income statement, one of the three basic financial statements for any business. This has a basic structure like this:
Income $X
Expenses $Y
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Profit $X - $YIf we succeed in selling all our toy cars for $5 apiece then our revenue or ‘top line’ is $5000. That’s how much money should come in over the course of the month in which our shop is open. From that we have to deduct the ‘cost of revenues’ or ‘cost of goods sold’, which in this case is the $1000 we paid for the cars. Deduct this from our revenue and we are left with $4000. This is our gross profit, revenues minus cost of revenues. If we divide this figure by revenue we get our gross margin, a whopping 80%. Excellent.
Income $5000
Expenses
Cost of revenues $1000
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Gross Profit $4000How are we actually selling the toys? Let’s make a store using Shopify. This adds two kinds of extra cost. At the time of writing a basic store will cost $29 for a month. This is money we will spend regardless of how much we sell, it doesn’t scale with revenue and isn’t a cost of revenue. This is the first of our operating expenses, the money we must spend to run our business. Shopify will also levy a transaction cost on each payment they process for us. This is about 2%. So each $5 we take when selling a car will cost us $0.10. How about the costs of posting the cars to the lucky recipients? We could charge this to the customer on top of the $5, but let’s keep it simple for now and say that our price is inclusive of shipping and that this works out as $1 per car, $1000 in total (1). That gives us $1129 in total operating expenses. Deducting both our cost of revenues and our operating expenses from our revenue leaves our operating profit.
Income $5000
Expenses
Cost of revenues $1000
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Gross profit $4000
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Operating expenses
Shop rental $29
Transaction fees $100
Shipping costs $1000
$1129---------------------------
Operating profit $2871
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Taxes $743
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NET PROFIT $2153
If this were an incorporated business with salaries paid either to ourselves or employees then this would be another operating expense. More likely in this case we are operating as a sole trader with no separation between our personal and business finances, and no concept of salary. We must still pay tax on our operating profit, the income we make after expenses. How much tax would obviously vary depending on where we live — pluck a number out of the air and say 25%. Deducting taxes gives us our net profit, $2153. This is great. Why doesn’t everyone do this?
The catch — customer acquisition cost
The difficulty with this otherwise brilliant-seeming business idea is this — how are we going to get people to visit an online shop they have never heard of and buy our toy cars? We’re going to have to advertise, and advertising will cost money.
Let’s propose a generous ad budget, $1000. That’s another operating expense, reducing our operating profit to $1871. But is it enough? Online ads work by setting a budget and a ‘cost per click’ that you are willing to pay in an auction for the exposure. If we pay $0.25 per click then $1000 should bring 4000 people to the store. If 25% of them buy our toy then we make our money, which is still pretty good.
The problem here is that the conversion rate for a typical online shop would be nowhere near as high. More likely it would be at best a tenth of this, 2.5%. If we assume that each customer buys exactly one car then in order to sell our 1000 cars we would need 40,000 people to visit our shop, at a cost of $10,000 in ads. Oh dear.
Income $5000
Expenses
Cost of revenues $1000
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Gross profit $4000
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Operating expenses
Shop rental $29
Transaction fees $100
Shipping costs $1000
Advertising $10000
$11129---------------------------
Operating profit -$7129
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Taxes $0
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NET PROFIT -$7129
Clearly we can’t spend $10,000 to make less than $3000. Can we try to minimise our losses by selling at least some of our inventory of cars? Here is where it is useful to think of our ads not as an operating expense but as a cost of revenues, something at least conceptually possible with a digital cpc ad. With a 2.5% conversion rate we need on average to bring 40 people to our shop to sell one car. At $0.25 per click that’ll cost us $10. Add that to our existing purchase, postage and transaction costs and it gives us a cost of revenues as $12.10 per car, to yield a revenue of only $5. Every sale will lose money.
Customer acquisition cost is one of the most important concepts in digital product management, and in this case it completely sinks our simple business.
There’s one obvious way to change the economics of this proposition — why have our own shop? Most people running this kind of business would sell via a platform like eBay or Amazon Marketplace. People with children who like toy cars will come to those sites directly to search for them, and it becomes much easier to acquire customers. The downside is increased competition — there will likely be many sellers of similar products competing fiercely on price.
Is there any way we can make our own toyshop pay? In the next post we will start to explore the question further by removing some of the constraints in our scenario, like each customer buying only one car or our only operating for one month. This will involve thinking about important concepts like customer lifetime value and cash flow.
(1) At first it seems like transaction costs and shipping to customers should be a cost of revenues, and I had to check this. However they are typically accounted for as operating expenses. If we decided to sell the cars for cash at a local xmas market we could escape these on some sales. Whereas the costs of shipping the cars from the supplier to us cannot be escaped and are accounted for as a cost of revenues.
