Chapter 12 How to Evaluate Your Costs and Profitability on Amazon [Infographic]
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As an Amazon seller, you need to ask yourself one important question: “Is my Amazon business profitable?”
The answer isn’t as obvious as you might think.
Many sellers discover they are losing thousands of dollars every year. This is because they’re using one-dimensional metrics to determine profitability. You can’t tell a person’s health by simply checking his heart rate, so why would you do the same for your Amazon business?
To effectively evaluate your profitability, you must analyze every aspect to determine your overall inventory health. This is what we call the Multidimensional Methodology.
The Multidimensional Methodology will help you determine your profitability at the SKU level so you can make the most informed business decisions. This may be regarding your pricing, inventory management and restocking, returns management, vendor negotiations and more.
First, we’ll go through the most effective methods to measure profitability on Amazon, and then we’ll get into the specifics of how you can squeeze the most profit out of each dollar you invest.
Read through the infographic here to get a pulse on the health of your Amazon business, with details below on how to exactly determine your Amazon channel profitability.
Know Your Costs
If someone were to ask you if you knew your exact costs at the SKU level, would you be able to answer “yes”? Even the most organized sellers are missing out on hidden costs that are affecting their bottom line.
Let’s get started with a review of the minimum list of costs that should be considered in your financial model. These are recommended by James Thomson, partner at the Buy Box Experts and former head of Amazon Services (which recruits >99.5% of all new sellers to the Amazon marketplace each year).
- Direct costs: Your acquisition cost per SKU, including shipping.
- Indirect (overhead) costs: Warehouse costs, utilities, insurance, bookkeeping, payroll and benefits, business travel, corporate business tax, product samples, web development, etc.
- Amazon fees: Sales commission, FBA fees, FBA inbound shipping fees, commission on returned product, storage fees, return shipping costs (both from customer to Amazon fulfillment centers, and from fulfillment centers to you), and returns disposal costs.
- Costs for handling returns once they are received: What write-down or write-off costs do you have by not being able to sell these returned products as new condition products?
Determining Your Overhead Allocation Cost per Unit
Your overhead allocation cost per unit is the best way to continually check up on your business and make sure you are remaining profitable on Amazon, all expenses included. This calculation has been used by James Thomson and Alasdair McLean-Foreman, CEO of Teikametrics, for more than a decade to determine overall success of a brand’s Amazon channel.
To calculate this, add up your indirect costs over the past twelve months, and divide that sum by the number of units you sold in the last 12 months. Use this number as a rule of thumb, as it should be consistent on a month to month basis.
You may want to refresh this calculation every six months. Let’s say, for example, that you calculated a $2.00 overhead allocation cost per unit sold. This is how much money you have spent on the sale of the item before you have purchased or sold it.
Typically, we see overhead allocation costs between $1 – $3 per unit. If your overhead allocation cost is higher than that, it may be time to evaluate your individual business expenses and determine how to streamline your costs.
For example, let’s say Kathy’s Cat Toys is spending thousands of dollars on Amazon Sponsored Products every month to drive traffic to her Cozy Cat Castle. However, her return on her investment is three sales per month. Based on the high overhead allocation cost for that particular unit compared to her other SKUs, she will have to determine if that SKU is worth continuing to sell.
Take a Look at Your Amazon Fees
All Amazon fees can be pulled in one to two week time frames out of Seller Central (Seller Central > Reports > Payments > All Statements View).
Keep in mind your FBA fees will be higher for items that are heavy or large. Also, be sure to monitor any slow-moving SKUs, as stale inventory can cause you to rack up additional fees.
Lastly, while some of your expenses may be SKU specific, some are not. Once expenses are calculated by individual SKU, the remaining costs should be allocated across all units sold.
This is a very simple approach to profitability calculations and will provide you the minimum amount of information you need to monitor your costs day-to-day, or month-by-month.
To summarize, let’s review your costs:
- Wholesale cost
- Inbound/outbound shipping
- Amazon commissions
- FBA fees
- Overhead cost allocation
- Returns-related costs
Unfortunately, if you don’t have a constant pulse on your profitability by SKU, it can be difficult to make the necessary changes to vendor negotiations, inventory management or product sourcing promptly.
By moving toward a model of profitability by SKU (updated every 3-6 months), having a decent understanding of the overhead allocation cost that you should be applying to all current sales, and knowing the impact of product returns on your SKU-level and overall profitability, you can become a smarter seller.
This knowledge will help inform and educate future buying decisions.
If Kathy’s Cat Toys is selling a lightweight, feather toy that is incurring minimal FBA fees, has low overhead costs, and sells like hot cakes, Kathy knows to reorder that toy. However, the Cozy Cat Castle that is heavy, large, and is slow-moving is a SKU that Kathy should consider to no longer purchase or even remove from FBA so as not to incur further fees.
A lot of smaller brands choose to track all of these calculations through spreadsheets, but this can be extremely inefficient and time consuming. Most successful mid-market sellers decide to employ a third-party software to automate this process and help them determine their true profitability.
Identify Trends That Are Costing You Money
While some products may have a high return rate (e.g., 20% of orders are returned), you may easily be able to resell all of those items as ‘new’ condition a second time if a customer doesn’t open or tamper with the product before returning it. Other products may have low return rates, but are a complete write-off if returned (e.g., software, vitamins, underwear).
If you are forced to resell the SKU as ‘used’ following a return, there is a write-down cost incurred by not being able to generate the revenue you would have received were the item in ‘new condition.’
For example, if you are selling an iPad and the customer chooses to return it, you would have to sell the item for a lower price as ‘like new’ or ‘used.’
As products are returned, you should be tracking not only the proportion of each SKU being returned but also the cost per return regarding write-downs or write-offs. This can be found in Seller Central reports or automated through third-party software.
It’s crucial to monitor return rates and return-related costs because occasionally, those costs will actually be high enough to warrant removing the products from your catalog. Alternatively, you may have the option to push part of that cost onto your distributor/supplier with whom you share the returns-related cost data.
For example, let’s say Molly’s Marionettes have seen a large number of returns. After Molly does a returns analysis, she finds that she is losing money. Once she removes the problem product from her catalog, she sees a 10% increase in profit the next month.
Inventory stockouts happen to even the most experienced Amazon sellers and have the potential to be one of the biggest leaks in your profitability bucket.
How much are inventory stockouts costing you?
Let’s go over an example of just how much of an impact stockouts had on Steve’s Sporting Goods.
Steve is an established Amazon seller with over 5,000 products and his top seller is a pair of high-end soccer cleats. The cleats have been flying off the shelves and are selling at an average of 60 units per month, with a profit of $50 per unit.
On average, Steve is out of stock on these cleats an average of 2.5 days per month, equaling a loss of $1,500 in profit over the course of the year ((2.5 days x $50/unit) x 12 months in a year = $1,500). While this may not seem like a lot, let’s consider Steve’s business as a whole.
Using the Pareto Principle, or the 80/20 rule, we can assume that 20% of Steve’s inventory generates 80% of his profits, so 1,000 of his 5,000 SKUs. If we estimate that on average, his profit per SKU sold is $10 and he sells 10,000 of his top 20% of SKUs.
If Steve were able to cut his average stockout time per month in half, he would make an additional $50,000 of profit each year.
Why Stockouts Happen and How to Prevent Them
Scenario 1: An Increase in Customer Demand
Some changes in demand will be unpredictable, like when Kate Middleton wears a particular dress (known as “the Kate Middleton Effect”) and sales shoot through the roof.
How to Prevent this Stockout Scenario: Not all stockouts can be remedied with the same solution. First, take a look at the type of product you’re selling.
Since the “Kate Middleton Effect” is hard to predict, the best solution is to build a buffer into your buying strategy to prepare for scenarios like these. Keep in mind that this strategy has drawbacks as well. If your product doesn’t sell, you risk paying those pesky FBA storage fees.
Scenario 2: Annual Seasonal Variations
Every retailer knows that when spring begins, your winter boot sales become slower than molasses in January and your rain boots and sandals begin to fly off the shelves. For many sellers, this often results in stockouts.
How to Prevent this Stockout Scenario: If you are selling seasonal items, you’ll want to monitor changes in your historical sales rank and stay on top of other factors, like weather patterns, to help predict inventory levels. This can be tracked through spreadsheets or third party software.
Scenario 3: Complications with Your Supplier
Occasionally, you will run into supplier issues that are outside of your control. For example, Nike decides to discontinue your best selling running shoe or your wholesaler ran out of stock.
How to Prevent This Stockout Scenario: Be your supplier’s best customer and maintain open lines of communications with them at all times. This way, you can be alerted in advance to any changes in their product line or SKU volume and adapt your strategy accordingly.
Most importantly, you’ll know if any of your best selling items are about to be discontinued, giving you the ability to buy up a bunch of extra inventory so you can continue to enjoy these sales for as long as possible.
Scenario 4: Changes in Demand Resulting from Competition
There are two potential causes for this scenario:
- Your Kitchen Aid blender has been struggling to sell for weeks and all the sales have gone to your competitor, Kelly’s Kitchen Supplies. All of a sudden, Kelly runs out of stock and you’re the top seller on the listing. This causes demand of your blender to go through the roof and you are not able to keep up, causing you to go out of stock.
- The opposite scenario happens when Amazon sees the success you are having with your Kitchen Aid blender and begins to sell the same SKU. Now you are never able to win the Buy Box, no matter how low you go with your price.
How to Fix This Stockout Scenario: It’s crucial to regularly monitor your sales volume and price changes to catch variations in sales velocity for your SKUs. This will help you catch the first cause as quickly as possible so you can adapt your strategy. Depending on your competition, you may want to increase your price to get even more of a profit margin out of this temporary spike in sales.
Competitors jumping on a listing is becoming more and more of a common occurrence. To properly prepare for this particular situation, always be diversifying and expanding your portfolio so that losing a few SKUs won’t make or break your business. The more diverse you are at the brand, supplier and SKU levels, the lower your risk.
Always be scouting for new brands to sell so that if your best supplier begins to sell directly to Amazon or if your supplier cuts you off completely, you have more profitable products to rely on in your portfolio.
Know Your Metrics
Key Performance Indicators (KPIs) are crucial for the success of any business. These metrics can help you evaluate your success at reaching key targets, allow you to spot trends or problem areas, and assess your overall performance. They are used across all industries but are particularly useful for retail businesses.
The most successful Amazon sellers know to segment their analysis by brands, suppliers and buyers, and review metrics for each of these areas at least once a week.
Here are the most important KPIs to evaluate the health of your Amazon business:
Inventory to Sales Ratio
This key management metric covers multiple areas of your business. It indicates the overall health of your inventory, as well as highlighting your sell-through rate.
This ratio shows how many times a company’s inventory is sold and replaced over a period of time. A low turnover rate implies poor sales and, therefore, excess inventory.
Gross Margin Return on Investment (GMROI)
GMROI is a ratio used to evaluate inventory profitability. A ratio higher than one means you are selling the merchandise for more than the total cost it took to acquire it.
Cash to Cash Cycle
Cash to Cash Cycle measures the amount of time it takes for capital invested to go from cash to the production and sales process and then convert into cash again through sales. This metric looks at the amount of time needed to sell inventory, the amount of time needed to collect cash owed, and the length of time the company is afforded to pay its bills without incurring penalties.
The longer your cash to cash cycle is, the more time your cash flow is tied up. This means you are losing out on potentially more profitable investments.
Days of Inventory (DOI)
This KPI will help you see the average number of days an item is held in inventory before it is sold. It’s extremely useful in determining order quantity to ensure you are not overstocking or stocking out of your inventory. Days of inventory (DOI) is much higher for companies not tracking KPIs.
Tracking your metrics is key because the dollars are in the details. While these details may seem minute, when the mistakes add up they can make or break your business.
Here are some commonly missed profitability leaks unique to Amazon sellers:
- Returned items that are lost or damaged: Occasionally, items returned by customers are either lost or damaged in transit and the seller of that item never receives it.
- You don’t receive your refunds: When a customer returns one of your products to Amazon, Amazon immediately refunds the customer the amount they paid for the item. However, occasionally that refunded payment never makes it back to the seller’s account.
- Amazon does not receive your shipments in full: It’s common for parts of your shipment to get lost or damaged along the way to Amazon’s fulfillment centers. It’s crucial to confirm the SKUs you sent over to FBA match up with the shipment Amazon has received.
- The SKU quantity sent from your vendor is incorrect: Check, check and re-check again that the quantity you receive from your vendor is the same as the quantity you are expecting.
Now that you know about some of the most common profitability leaks and the key metrics you need to pay attention to in order to evaluate your true profitability, let’s talk about how to squeeze the most out of each dollar you invest.
Use Your Profitability Analysis to Squeeze More Out of Your Dollar
Lay all of the facts out on the table and perform an audit on all of your suppliers. This will help you spot areas where you can negotiate to get better deals.
For example, the seller in the example below should be able to leverage their large sales volume and five-year relationship to negotiate better payment terms.
Now that you know your most profitable SKUs using the metrics we outlined, use your findings to inform your future buying decisions.
Also, remember that the more diverse your portfolio is, the less risk you have of seeing a large drop-off in profit in case one of your product lines is discontinued or your brands go out of business.
Historical profitability trends
If you identify that your pink oven mitt sales have been decreasing over time, it’s time to consider whether or not you want to reorder that product. Remember that all products have a lifecycle –– the key is to pay attention to trends.
Consider third party solutions
Seller Central’s reports are often not thorough enough and spreadsheets can be a pain to update and manage. Save time by automating processes that can be more effectively managed by technology.
If you are interested in learning more about how you can automate the processes outlined above to identify your true profitability at the SKU level, contact the good folks over at Teikametrics.