The following is a transcript of Episode 36 of Return on Podcast, the show where we help e-commerce sellers improve their ROI in business and in life. For more episodes, subscribe to our YouTube channel or listen on Podbean, Apple Podcasts, Spotify, and Amazon/Audible.
All right. Hi friends. I’m Tyler Jefcoat. Welcome to the Return on Podcast miniseries called From Pain to Profit in 2023. This is the fifth segment of this series, and the first four were the first one related to vision and getting organized as a leader. The second one is you gotta get your bookkeeping in order.
The third one was we worked on redefining gross profit to include advertising. We called it PAG, post advertising gross profit. The fourth session was the most recent one, and it was related to that more than is the most common question that I get as a CFO. Tyler, how much can I afford to spend on my advertising? What should my TACOS actually be? And we looked at redefining that question to include our Cost of Goods Sold. We don’t know how much we can afford to spend on ads until we know what our Cost of Goods Sold percentage is. That was that fourth section, and now today we’re gonna talk about another really important KPI, and it’s called ROII or Return on Inventory Investment.
If you and I were to buy a piece of real estate, we put some amount of money into it and we got some profit in the form of rental income or something like that, we would take that profit divided by what we invested, right? So you’re thinking about, if you’re remembering your middle school math, the numerator is the profit, the denominator is the investment. And once we do that on our calculator, it’s gonna give us a Return on Investment. That would be for real estate.
In e-commerce, we make an important long-term investment, and it’s inventory. And so we can actually do that exact same calculator, looking at our inventory. And the beauty of this metric is that unlike some of these metrics, I don’t need to know your inventory balance. We don’t have to track your balance sheet metrics. All I need is profit and COGS.
In other words, if you can tell me what your product Cost of Goods Sold were for any period, for a day, for a month, for a year, and if you can tell me what your profit was for that same period of time, that same day, or that same month, or that same year, then we can kind of, if you can envision your profit and loss statement, obviously you have sales, then you have your product COGS, and then you end up with that PAG number, that post advertising gross profit number. We’re just going flip ’em on their head and we’re gonna do a profit divided by Cost of Goods Sold.
Really common scenario for a lot of the Amazon dominant sellers that we serve is we got about a third of our budget in product COGS. So let’s say that product Cost of Goods Sold was 30%, and after Amazon fees and advertising, we’re left with 25% in profit, our true gross margin.
So if I were to take that profit, divide it by those COGS, and again, if you’re listening to this, you won’t see this, but this one’s pretty easy to understand. On the YouTube, you can see that profit for this period was $100,000. And to generate that a hundred thousand dollars profit, we needed $120,000 in Cost of Goods Sold. A hundred thousand in profit divided by 120,000 gives me an ROII of 83%.
I want you to think about this ROII number kind of like a batting average. I dunno if anyone here is a baseball fan. My Braves let me down this year here in the state of Georgia. But you think about a great batter. The likelihood or the expected success each time that batter goes to the plate is called a batting average. That’s the how often they’re successful. Your return on investment for your inventory is similar in that every time you get to turn your inventory, in the example we just talked about, you get your dollar back plus 83 cents in profit. That’s pretty good.
By the way, there’s a reason that all of us are in the e-commerce space. If you and I were looking at a real estate investment, it could get an 83% return investment, we would be shocked. That would be amazing. That would be a really strong return investment. Now, real estate’s a lot less risky than e-commerce, right? You and I end up burning inventory because we have too much of it, or we have overhead that has to come onto the P&L after this, or Amazon can shut us down, or we can have competitors.
And so there’s a reason that we have to demand a fairly high return on investment as e-commerce owners, where if, again, if you’re investing in like a duplex in your city, you may be able to tolerate more of a 20% ROI or 15% ROI.
So to pivot into that question, what was it, what would a good return on inventory investment look like? I think the closer to 100, in other words, I get a dollar in profit for every dollar in Cost of Goods Sold, I think that’s ideal.
I think the example we’re looking at here is 83%. That would be a really good return on inventory investment. I think if it’s lower than 50%, so if, again, take your whatever, your last year or your last month’s P&L, and take that after advertising profit number and divide it by your actual landed product Cost of Goods Sold. If that number’s less than 50%, ay yai yai, you might be dealing with a flimsy business model where you’re gonna feel some cash flow pressure, and you may want to go employ some tactics to try to improve that return on inventory investment.
Obviously improving profit is the whole key here, right? So can I increase my prices, decrease my refunds, decrease my Cost of Goods Sold for my suppliers? Re-engineer my boxes to get lower FBA fees or do more efficient advertising. All the things that we’re like, oh, great, just do better. I understand how trite that sounds, but if your return on inventory investment is relatively low, you have to have extraordinary velocity.
And that’s what we’re gonna talk about in the next two videos is how to – there’s a reason, by the way, that wholesale arbitrage sellers, some of these guys out there are still doing tremendous profitability, even with really low return on inventory investment. And the reason and the secret is velocity. And so our next couple of videos are gonna be related to how to measure velocity, how to improve it, how to understand the true health of your business.
But just know that this is the other main profit metric, and it’s return on inventory investment. Come back next time for the kind of understanding true velocity and final video related to return on working capital. Take care, guys. Have a good day.