The eCommerce market continues to grow as consumption habits change and technology evolves. Statistics show that in 2019, only around 13.6% of global sales occurred online. But by 2024, that percentage is projected to reach 21.8%—an 8.2% increase in a mere five years.
Thanks to user-friendly platforms like Shopify, many people are beginning to establish their own eCommerce businesses. Although these interfaces make tasks like setting up a store and listing products quick and simple, there are still other aspects of running a business that first-time sellers need to become familiar with. Accounting is one of these. Understanding accounting basics can help you predict and plan for the future growth of your eCommerce store.
If you’re just starting out, we recommend getting familiar with the twelve eCommerce accounting concepts below so you can be equipped to make smart decisions regarding your online business
#1. Business entity
“Business entity” refers to the way your store is classified for legal and tax purposes. Understanding the different types of business entities will help you decide which type yours should be. Most small businesses elect to be a sole proprietorship or limited liability company (LLC), but you should research each option to make the best choice for you.
#2. Cloud-based Accounting Software
Accounting software, although more complicated than spreadsheets at first glance, is more scalable than manual accounting methods. It also reduces human error, increases efficiency, can be connected to eCommerce platforms, and can generate financial reports. Cloud-based accounting software specifically makes it easy for you and any other employees of your business to access financial information from multiple devices. Some type of accounting software is a must-have for most if not all eCommerce businesses.
#3. Accounting Methods
Although accounting software can help you generate financial entries and reports, you should also have a personal understanding of concepts such as cash and accrual accounting.
With the cash accounting method, a merchant adds a new record whenever cash is deposited in or leaves their bank account. It’s generally the preferred method of accounting for small businesses and is beneficial for short-term decision making. In contrast, accrual accounting means that a new record is added the moment a sale or expense takes place, even if the money has not been transferred yet. It’s a bit more complex but makes long-term projections and decision making easier.
When doing accounting, it may be wise to leverage averages when there are a lot of variables, especially if you aren’t or don’t have a professional accountant. An example would be if you purchased raw materials from multiple suppliers who each charge a different price. In this case, you could opt to use a weighted average to find the cost of each unit of raw materials to make things easier.
#5 Cash Flow
It’s important for merchants to attentively monitor their cash flow statement in the early stages of their business, especially. This is because there are various costs associated with getting a business off the ground, and keeping track of each will ensure you always know where you stand. Sellers should understand the timing and delays of any cash movement to be able to plan accordingly.
For this purpose, cash flow reports are sometimes more indicative than profit-and-loss statements, which can be skewed by accounting adjustments and changes in working capital. This is especially true in the eCommerce realm, since most cash is typically tied up in inventory which may be overstocked. Finally, merchants should also regularly complete bank reconciliations as a way to detect fraud and accounting errors associated with cash flow in particular.
#6. Balance Sheets
Whereas income statements are a snapshot in time, balance sheets provide eCommerce merchants with the bigger picture of their business. The three components of a balance sheet are:
- Assets: Things of value
- Liabilities: Debts or uncompleted payments
- Equity: Assets minus liabilities
For a business to be sustainable, it should have positive equity. Since calculating and keeping track of all of the above is so important for any business, all online merchants should learn the basics of keeping a balance sheet.
#7. Seasonal Budgeting
eCommerce businesses may be susceptible to one or more slow periods each year. To prepare for this, it’s wise to put money away to pay for the fixed costs that will occur during these times. It’s also smart to adjust stock accordingly for slow and rush seasons in order to cut costs and boost profits. Both of these tasks hinge on an understanding of the different seasons of demand for your particular product and niche so you can budget accordingly.
#8. Cost of Goods Sold (COGS)
Cost of goods sold (COGS) is the expense that’s tied directly to a merchant’s products. It consists of three costs:
- Direct material, which is the cost of your product’s raw materials including taxes and shipping fees.*
- Direct labor, which is the cost of the labor required to turn raw materials into the finished product.
- Manufacturing overhead, which includes the rent, utilities, and supervisory staff costs of your workshop.
*The shipping fees of an item may or may not be included in COGS calculations, although including them could potentially paint a more accurate picture of your affairs.
An accurate COGS is important for calculating your eCommerce business's gross profit.
Although sales events and lower prices can attract more customers, eCommerce business owners should always keep their profitability in mind. Profitability metrics allow merchants to devise pricing structures and strategies that yield the best results. Below are some useful metrics to know and consider:
- Operating margin: Derived by deducting the expenses of your primary business activities from your business earnings
- Net profit margin/net income: Your business’s bottom-line earnings, derived from your operating margins minus your income tax and non-business expenses
- Contribution margin: Measures the profitability of products after variable costs (direct material, direct labor, variable manufacturing overhead, and shipping costs) are subtracted
- Gross profit margin: Measures the profitability of products after all product costs. It’s essentially the contribution margin, though the gross profit margin also includes the fixed manufacturing overhead costs. The higher the gross profit margin, the more a business retains for each dollar in sales.
- Break-even point: How many products or how much profit a business needs to sell in order to negate the costs (i.e. no profit nor loss)
When looking at financial statements, merchants should consider areas in which they can cut costs. They should also focus on understanding and making better use of especially profitable strategies or products.
#10. Shipping to Customers
Tracking shipping costs allows merchants to determine the shipping fee they charge customers. When bookkeeping, you should credit shipping expenses for the shipping fee you charge, creating a negative balance in your shipping expenses to be offset by the actual shipping cost. If the fee charged exceeds the actual cost, record the expense first and then recognize the additional income.
#11. Sales Discounts, Returns, and Allowances
Sales discounts, returns, and allowances are fairly common in eCommerce businesses, especially with stores that sell clothing. These must all be recorded in the merchant’s accounting to accurately reflect their business’s performance.
Sales discounts, returns, and allowances should be recorded separately before being subtracted from the sales account in order to better track sales activity. Create two accounts in the chart of accounts in your accounting software: “sales discounts” and “sales returns and allowances.” Note that although regular discounts are recorded in the first account, discounts on defective merchandise belong in the second.
eCommerce taxes are known to be quite complicated. However, for smaller businesses, eCommerce platforms like Shopify are usually sufficient for taking care of setting the proper tax rates for customers.
As for paying business taxes, it’s important to prepare for this well before the time comes to file. Fortunately, eCommerce businesses can deduct many ordinary and necessary business expenses. Some examples include salaries, office rent, equipment costs, and accounting services. It’s always best to get advice from a professional, licensed accountant in your country when preparing to file.
Strengthen Your Accounting Knowledge to Build Your Business
Managing a business can’t be simplified into "making money" or "losing money." Whether you’ve just entered the eCommerce industry or have already achieved some results in the market, it’s important to keep up with your accounting and regularly review reports to understand the progress of your operations. To learn more about eCommerce accounting, check out these 16 common eCommerce accounting mistakes to learn how to avoid them.
If you use Shopify and have not yet integrated it with any accounting app, use Shypyard to quickly and directly complete the integration. Shypyard is suitable for all merchants who use Shopify; register now for free! If you’d like to know more, check out the benefits of automating your accounting with Shypyard. If you’re using another accounting app currently not selectable on Shypyard, contact us at email@example.com. We’d be happy to evaluate the feasibility of a software integration for you.
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