Two words every business owner focuses on. Maximizing the first helps increase the second. Sounds simple, doesn’t it? Well, of course, it is a little more complicated than it may first appear. You have to consider a few other factors before ordering that Aston Martin or luxury yacht. Business is always competitive and that is especially true when it comes to ecommerce.
Ecommerce is huge. It covers everything from “simple” stores selling hand-made products to innovative companies like Skullcandy. While Skullcandy’s growth saw a boost due to the COVID-19 pandemic, it was already showing constant and healthy growth prior and there do not appear to be many factors that will slow it down.
- US retail ecommerce revenue for 2020: $431.6 bn.
- Estimated US retail ecommerce revenue for 2025: $563.4 bn.
It is also worth remembering that ecommerce is not just about online shopping from established ecommerce stores, known as Business to Customer (B2C) transactions. There are also Business to Business (B2B) transactions where businesses deal directly with one another. A major growth sector within ecommerce is the Customer to Customer (C2C) market that includes selling via platforms such as eBay and Etsy. C2C sees many long-term partnerships formed, something that can be a crucial part of your growth marketing strategy.
You already know the markets are growing and you already know that revenue and profits are the two magic words. On the other side of the coin are your overheads. As tempting as it may be, before you can start browsing that yacht catalog, you know that your revenue needs to outstrip, ideally far outstrip, your total overheads.
What are all the overhead costs you might face? How do you track them over a financial year? And, most importantly of all, are there ways you can reduce these overhead costs?
What Is an Overhead Cost?
Simply, your overhead costs are the expenses you incur during the daily running of your business. They exclude any costs that are linked to the actual creation or formulation of a product or service. It doesn’t matter how successful you are, handling these expenses well is what enables you to stay in business.
For example, let’s say you run a carpentry business. The lathes, saws, and other tools you use would not be classed as overheads because they are what you use to make your products. Costs such as rent for your carpentry business, the electricity, the water, staff costs, would all be classified as overheads as you incur these costs even when not producing.
New office equipment (or maintenance of existing equipment) is also to be viewed as overhead expenses. If you decided to purchase the best video conferencing equipment for your organization, that too would be listed as an overhead.
Types of Overhead Costs
Not all overheads are the same. When planning to launch a new business, it helps to understand the three main types of overhead costs you may face.
1. Fixed overhead costs.
Your fixed and direct costs are ones that do not change, even if you have ramped production up or decreased it. They are a necessity in ensuring your company runs smoothly as far as day-to-day operations are concerned.
Some good examples of fixed overheads include:
- Any rental on your facility or office space.
- Full-time management salaries.
- Insurance costs.
- Property taxes.
- Depreciation of any fixed assets.
2. Variable overhead costs.
Variable costs are those expenses that may fluctuate with a change in your production levels or an increase – or decrease – in the number of services you provide. If your production fell to zero, you would have no variable costs, but if you dramatically increased it, so would your variable overheads.
Good examples of possible variable costs are:
- Any supplies and/or raw materials needed for production.
- Sales commissions given to the sales teams or other sales outlets.
- Office supplies.
- Shipping costs.
- Some utilities.
- Labor costs where you have had to employ or lay off staff due to demand.
3. Semi-variable overhead costs.
Semi-variable costs lie between our other two types. They are always present but their level can fluctuate according to other factors. They may have one foot in the fixed cost camp, but with semi-variable factors, this affects how much you have to pay. For example, if your organization uses a certain number of vehicles, they will incur some fixed costs, but increased use would be semi-variable costs or indirect costs.
Other examples include:
- Any overtime paid.
- Bonuses paid to staff (for example, at Christmas).
- Freelance sales people’ salaries and commission.
- Some administrative costs and services such as bookkeeping or janitorial services when you may need an increased level of service.
- Seasonal changes to utility costs.
How Do You Track Overhead Costs?
It can quickly become obvious that, in some circumstances, overheads can be confusing. That means that tracking these costs is integral to efficient operations. The first thing you need to do is have your in-house accounting team analyze and categorize all the costs you incur. Fixed and variable costs are fairly easy to track, but semi-variable costs can be trickier, especially for small business owners and startups.
Important KPIs to Track
In order to retain focus on that magical profit margin, you need to also firmly focus on the costs you are incurring. You should closely monitor and analyze several KPIs related to your business operating expenses.
1. Gross profit.
Your gross profit is what your organization earns once you subtract any costs that are linked to the production and selling of your products or services. The only overheads that are included in this are any that are directly linked to that specific production. The simple formula to calculate your gross profit is:
Gross Profit = Revenue – COGS (Cost of Goods Sold)
If your business made $1 million in sales over a year, and your total COGS was $750,000, then your gross profit would be $250,000. As far as labor is concerned, only labor costs involved in production should be included in your COGS figure.
2. Average margins.
Your average margin is the revenue you have left after paying your COGS. In order to calculate what your average margin is, you need to divide your gross profit figure by your actual revenue.
For example, going back to the woodwork business example, you sell bookshelves at a unit price of $400 each. To produce and sell each unit costs you a total of $300, thus giving you a gross profit figure of $100 per unit. To find your average margin, you divide 100 by 400, giving you a margin of 0.25 or 25%.
3. Inventory levels.
Planning and managing your inventory levels is integral to your business’s overall efficiency. The ideal scenario is to have your inventory level directly linked to sales levels and sales forecasts. So, if you forecast a 25% rise in sales for the following year, you should plan inventory levels to also grow by 25%.
Managing inventory levels poorly could lead to:
Too much inventory.
- Funds tied up in inventory that could be used elsewhere.
- Extra costs for storage and any additional linked costs such as refrigeration.
- Possible loss of value and demand if items are time-sensitive or are superseded by newer versions.
Too little inventory.
- You may not be able to meet market demand and customers may choose to go to a competitor who has sufficient inventory.
- Loss of confidence in your business and damage to the brand.
- Higher costs if you are buying small amounts of inventory as you lose the discounts that come with bulk purchases.
4. Overall labor effectiveness.
Your Overall Labor Effectiveness (OLE) is a KPI that refers to your workforce and measures how they perform, their quality, and how you utilize them.
These three factors are key to how efficient your overall production and business activity is.
- Performance: how well they work in producing a product or service, so measured by the total products/services produced in a given timeframe.
- Availability: what percentage of time your staff spends making active contributions to your business needs.
- Quality: how good the end product is and what percentage of total production is saleable.
Return on Investment (ROI): one of the crucial KPIs that you will always keep an eye on. Your ROI measures how profitable producing a particular product or service is. Measuring your ROI is a key indicator in making decisions on whether to continue or discontinue a product or whether you want to increase or decrease production.
For example, let’s say those wonderful bookshelves have brought in total revenue of $200,000 in a year. Your total costs were $150,000.
ROI = (Current value of your investment – cost of investment) divided by cost of investment
Using this example, your return on investment (ROI) would be 33.33%.
6. Cost variance.
You will have lots of experience in planning and allocating budgets. You will also know that the figure you allocated may often not be the final figure as projects come in both over and under budget. Cost variance (CV) is the KPI that refers to how much under or over budget you are.
To put it simply, your CV is the difference between your actual final costs and what your original forecast or planned budget was.
CV can be categorized in three simple terms:
- Positive: where the project has come in under budget.
- Negative: where it has come in over budget.
- Zero: when it comes in on budget.
How Do You Reduce Overhead Costs of an Ecommerce Business?
So, you understand the terminology related to your overhead costs. The important question is how do you reduce your ecommerce business’s overhead costs to welcome profitability (and that sleek yacht)? You may already be looking at other ways of making cost reductions: holding a virtual meeting instead of a physical one can save on travel costs, for example.
1. Make it a habit to track your expenses.
You may look at some minor expenses as being relatively inconsequential but those small figures can add up over the course of a year or more. In the long run, they can make a real difference to your bottom line. It is crucial that you track each and every expense as early as you can.
If you are a sole proprietor or small business just embarking on your ecommerce journey, you may not have a dedicated accounting team and may not want to add extra expense for any external service you use. Just by using spreadsheets or simple business software, you can easily track every expense and even identify trends or expenses you can reduce or even remove entirely.
Close monitoring of expenses can help identify areas where downsizing will be beneficial without affecting efficiency. It can keep track of areas of excess expenditure that may have a knock-on effect with other areas of your budget such as hiring decisions.
2. Re-evaluate your packaging and check if it’s efficient enough.
When starting out, many ecommerce organizations opt for the simplest and most affordable packaging option at the time, but this may not manifest as real savings over an extended period. Using oversized boxes or too much packing material (to fit a smaller product in that oversized box) could add significant extra expenses each month.
When you look at companies like Blissworld, they face the challenge of having many small-sized products but also often have to ship multiple products. Look at what the most common monthly send-out items are. Ensure that you are using cost-effective boxes that suit the products you send and try to minimize any packing material used while still guaranteeing box contents are protected.
3. Check your shipping system & fee pricing.
Outsourcing the shipping of your products can end up being a major expense, especially if you offer free shipping. Remember that the third-party logistics industry is huge, with an estimated value of $196.4bn in 2021. Shop around for the courier service that best suits the needs of you and your customers while remembering that the cheapest is not always best.
If you are offering free shipping as an incentive, ensure that the costs you are taking on do not adversely affect your ROI and other KPIs. Do not restrict yourself to one logistics provider, particularly if you ship both nationally and internationally. One provider may be ideal for local and national deliveries, while another may be better when it comes to international shipping.
If, like Bon Bon Bon, you sell perishable items, you want the products to arrive on time and in good condition.
4. Do an inventory check more often.
It’s crucial that you closely monitor your inventory levels. This is not only a case of being aware of current demand but also the demand you are forecasting and any relevant seasonal fluctuations. There is little point in having a high inventory of Xmas goods when it is only February. Plan ahead and plan well.
Flexible planning is crucial to your business – applicable when it comes to inventory control and planning. Look at your historical data and your forecasts as to what your expected inventory needs are for each product.
Inventory storage both incurs costs and can take up space that could be utilized for faster moving products. If you do find yourself with excess inventory, then look at how to reduce it. For example, you could offer it at discounted prices to create space, or perhaps bundle your excess products with other products on your website to encourage buyers.
5. Keep and kill: focus on top-performing products and eliminate excess products.
Consumer tastes and behaviors change over time. What was your best-selling product last year can quickly become your excess inventory the next. An important part of good inventory management is to carry out an ABC analysis. This can help you identify what your best-performing products are and what products are being left on your shelves.
An ABC analysis is not necessarily about the numbers of units being sold but rather what each product contributes to your total revenue. ABC analysis follows something called the Pareto Principle which is also known as the 80/20 rule.
This splits your products into one of three ‘grades’:
- Grade A: these are your star products, the ones that generate real revenue. Your Grade A products are the ones that account for 80% of your total revenue. Focus and prioritize products in this group.
- Grade B: These are your ‘average’ performers that contribute the next 15% of your revenue. While they do not need to be prioritized, they should not be ignored either.
- Grade C: These are the products that no longer perform or have never performed. They only contribute 5% of revenue and are probably taking up space. Ideally, you should be looking at removing these without experiencing a major loss.
6. Invest in the right market: your existing customers.
Everyone wants new business, but your main focus should be on retaining your existing customers and maximizing their CLV (customer lifetime value). It can be as much as four times cheaper to sell to an existing customer than to attract and onboard a new one. This means you get a far greater ROI if you focus on customer retention.
Marketing to your existing customer base can be easier and cheaper too. They are already signed up with you so should be receiving updates via SMS and marketing emails that include communications such as loyalty bonuses and special offers. It’s always a good idea to send out a regular newsletter to those customers letting them know what is going on with your site and any new offers.
Another great way to connect with both existing and potential customers is to launch a blog. Blogs can be both informative and educational while still promoting your products and services. Learning how to start a blog can be a great help with both customer retention and attracting new customers.
7. Forget quantity, focus on quality.
That ABC analysis we suggested can really help you focus on the quality of your products. It identifies the ones that generate the most revenue and that also usually means they are the products your customers liked. The measure of your ecommerce business does not come from how big your range of products is, it comes from how good they are and what customers think.
Regularly reviewing your product range, how they sell, and also what customers think can be a great way to ensure you are focusing on quality. Monitor the various places customers leave reviews and feedback; this could be on independent review sites, on your own site, and what people are saying on social media.
8. Go green: adopt energy-efficient practices.
‘Green’ is more than just a buzzword – it’s something we should all be thinking about for every aspect of our lives. For you, that could be in your products or in how you operate. If you look at how well Larq’s reusable water bottle (single-use plastic is bad!) performs, you may get some ideas.
Look at adopting energy-efficient policies in your workplace. That can be as simple as ensuring lights are turned off in unused areas to using energy-saving lightbulbs, refillable ink cartridges, or going paperless. If you can expand those ideas to things like solar panels to generate some or all of your power needs, you’re one step ahead of the game. This may require a significant initial investment but will offer massive long-term savings.
It is also worth discussing with your utility service providers what eco-friendly options they offer. In some circumstances, greener utility options may initially seem more expensive but do offer savings over time.
Why is it Important for Your Ecommerce Business to Reduce Overhead Costs?
Ecommerce is, generally, already fairly streamlined and offers significant savings over doing business from a brick-and-mortar store. This doesn’t mean it cannot be improved. You may already be using various technologies in your business model, such as video conferencing to keep in touch with customers and suppliers.
Having a modern communications platform is just one way to reduce costs over time. Examining every area of your business to see where improvements can be made can offer different levels of savings on your overhead costs that can add up to bigger savings. Why is it important? Reduced costs mean bigger margins, profits, and maybe even that yacht!
Technology is the beating heart of ecommerce – from your website to your mobile site to that whiteboard app you may use to train new employees. Businesses sometimes focus on technology a bit too much without considering all the traditional aspects that constitute your overhead costs or considering cost-cutting strategies.
While you should be installing an enterprise phone system if needed, take some time to look at all the other details. Where can you make savings? Where can you make improvements to your efficiency? Making cuts to some or all of your overhead costs improves your business, makes you more efficient and makes that dream of sailing the Caribbean a little closer.
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