Strategy Centre

Online Marketing Fees are a Cost of Sale and Not an Overhead

  
09 March 2016 14:06
  

Profitable sales generation is the key to online retail success.  When it comes to understanding commission and online marketing costs, it helps to appreciate the deep differences that exist between the ‘old world’ of traditional retail and the ‘new world’ of digital commerce. This has a major impact on how the Profit & Loss is viewed.

The fundamental difference is that online marketing and platform costs are a true Cost of Sale and NOT an Overhead (as advertising would have been historically).

Understanding the accounts in this way is key to online success and alignment from the accounts department to the online operation.

Traditional Retail Profit & Loss

Before digital commerce and multichannel, the business model for a retail environment was fairly straightforward: marketing and technology were generally seen as an overhead on the Profit & Loss.

Putting it simply, this meant that a Profit & Loss account would be structured as follows:

Traditional Retail P&L Account
Profit & Loss CategoryRetail
Revenues All sales ex VAT processed recorded at date of sale (further analysed by shop and/or department within shop)
Less: Cost of Sales Stock cost of each unit sold
Processing charges (e.g. credit card merchant fees)
Direct sales costs (e.g. staff on tills etc.)
GROSS MARGIN Revenues less Cost of Sales
Less: Overheads
Wages and Salaries Costs Non Direct sales costs (e.g. management & back office staff)
General Staffing & Office Costs Travel and subsistence costs
Training expenses
Establishment Costs Rent, rates, light, heat, cleaning & insurances
Advertising and Marketing Expenses TV and print media advertisements
Brochure printing and distribution
In shop merchandising
Communications and Systems Expenses Telephone
Licensing costs of systems (e.g. POS, stock control etc.)
Legal & Professional Costs Accountancy & Solicitor expenses
NET MARGIN (EBITDA*) Gross Margin less Total Overheads

* EBITDA means Earnings before Interest, Tax, Depreciation and Amortisation and is the most reliable benchmark for comparing profitability, before accounting for book entries, cost of financing and variable tax rates.

Some key definitions in this traditional retail account are as follows:

  • ‘Cost of Sales’ related to the cost price of each item of stock sold and any additional direct expenditure in servicing each sale, for example credit card merchant fees, etc.
  • ‘Advertising and Marketing Expenses’ were related to brand building, market awareness and general high-level activities designed to encourage people to buy, but could not be directly attributed to a specific individual sale.
  • ‘Communications and Systems Expenses’ related to systems in the business that were generally locally installed and licence based. They were fixed costs in the business that had no impact in generating sales; if the business sold nothing or sold one million items, these costs remained the same.

Where did a sale come from in traditional retail?

In traditional retail, it was practically impossible to attribute a TV or magazine advertisement for a retailer to a new sale in a shop later that day. The advertisement may have influenced the decision to buy, but so also might have factors such as the location of the shop or the helpfulness of the staff within the shop.

Digital Commerce Profit & Loss

Digital commerce models are vastly different. It is crucial that a retail-minded Profit & Loss is re-evaluated in light of the way that digital businesses generate sales and grow.

Understanding the new model is a crucial step in success in a digital environment. To demonstrate this, let’s define some key terms:

  • ‘Gross Margin’ is the difference between the sales generated in the business and the direct costs in generating each sale.
  • ‘Gross Margin %’ is the percentage of gross margin divided by the sales revenue (excluding VAT).

Where did a sale come from in digital commerce?

In the digital world, the key change is that new sales can easily and consistently be tracked to the advertising campaign from which it originated, for example a Google or Facebook ad, an email newsletter, or a referral from an affiliated site.

Because the cost of each advertising channel is effectively measurable in direct terms, and in direct percentages, the traditional Profit & Loss account therefore changes to:

Digital Commerce P&L Account
Profit & Loss CategoryEcommerce
Revenues All sales ex VAT processed recorded at date of sale (reported by channel of sale, international territory etc.)
Distribution charges (e.g. delivery fees, card processing fees etc.)
Less: Cost of Sales Stock cost of each unit sold
Processing charges (e.g. credit card merchant fees)
Paid search channel fees (e.g. Google AdWords, Bing / Yahoo, Facebook advertising etc.)
Affiliate channel commissions paid
IRP Sales Commission payable
Direct delivery expenses
Promotional discounts
GROSS MARGIN Revenues less Cost of Sales
Less: Overheads
Wages and Salaries Costs All staffing costs
General Staffing & Office Costs Travel and subsistence costs
Training expenses
Establishment Costs Rent, rates, light, heat, cleaning & insurances
Advertising and Marketing Expenses Only advertising and marketing not directly attributable to sales (e.g. exhibitions, general branding etc.)
Communications and Systems Expenses Telephone
Licensing costs of systems not directly attributable to sale by sale generation
Legal & Professional Costs Accountancy & Solicitor expenses
NET MARGIN (EBITDA*) Gross Margin less Total Overheads

A profitable and carefully managed business will have a deep knowledge and understanding of their gross margin and, more importantly, the capacity to pay out of that gross margin to generate new sales and still make money.

As long as the retained gross margin covers the business overheads, the business will be profitable.

More importantly, understanding the gross margin coupled with the CPA of individual channel campaigns, allows for straightforward decision making.

If, for example, the digital retailer:

  • Earns 30% gross margin per sale, and
  • Can generate new sales for a CPA of 20%, and
  • The retained 10% gross margin covers overheads at an annual revenue level of £1m,

then it should feed the advertising campaign for as long as the CPA remains at that level and revenue exceeds £1m.

The actual amount paid in the paid search campaign becomes irrelevant – the key business metrics are the gross margin and CPA percentages.

Digital Commerce Revenue Share

IRP Commerce together with your Systems Integrator (SI) operate a business model that is 100% aligned with your business strategy – to grow online sales as quickly and as profitably as possible. IRP Commerce and your SI operate a revenue share model so that the system and services are all paid from success in a totally aligned business model.

The IRP has been created to provide deep insights on the key metrics on your site around sales generation and profitability and to inform decisions on new campaigns.

It is for this reason that we position ourselves differently from enterprise software not motivated with your actual sales levels. In essence we are a digital cost of sale and not an overhead.

Our fee should therefore always be reviewed on a percentage basis and not as a quantum of money.

By capping the quantum of money spent each year, you are in effect reducing your ability to generate top line sales growth.

Instead we advocate that you look at our cost as a share of the gross margin generated by the new sales possible by using the IRP and the digital marketing services.

As long as that percentage cost is payable from gross margin you have a profitable business that will continue to grow with fuel in your advertising campaigns.

Comments

Anonymous - Interesting article and important fundamental principle for the digital era.
16 Mar 2016 12:34
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