Since we are interested in online retailing we can use a much simpler definition.  For retailing, the cost of goods sold is the price paid for the product plus additional costs necessary to get the product into inventory and ready for sale, including shipping and handling.  When drop shipping,  the wholesale suppliers price you pay plus the drop ship fee, if any, and any postage and handling equals the costs of good sold.  If you buy bulk from the wholesaler and have the items shipped to you business then the cost of goods sold would be the whole sale cost of the product plus the cost to ship the product to your business and any shipping and handling costs to ship the product to your customer.  If you use multiple product sourcing methods then your COGS is the sum of all methods used.

Drop shipping:    COGS = wholesale price + drop ship fee + shipping & handling cost
Bulk purchase:    COGS = wholesale price + wholesale shipping & handling + customer shipping & handling

Another way to determine your COGS is with the periodic method.  Using the periodic method, COGS is equal to your inventory at the start of the period plus purchases made during the period less inventory at the end of the period.

Gross Profit

Once we know our cost of goods sold we can calculate our gross profit.  Gross profit is simply the difference between our total revenue and our cost of goods sold.  This tells us the total (gross) profit we’ve made.  You need to make sure our gross profit is the same or higher than our operating expenses or our business will be losing money.   I will discuss operating expenses in my next post.

Gross profit = revenue – cost of goods sold

Gross Margin

Gross margin is very similar to profit margin and they are calculated using the same basic method.  The key  difference is gross margin uses total revenue and cost of goods sold from all of your sales while profit margin is revenue and cost from single sales.  Another way for view them are: gross margin is the average margin for all of your sales.  Profit margin is the margin for a specific sale.

Gross margin = (total revenue – total cost of goods sold) / revenue

One thing I forgot to mention in the post Wholesale Markup versus Profit Margin was that markup and margin have an inverse relationship.  This means that you can easily calculate one if you know the other.

Wholesale markup = 1 / profit margin
Profit margin = 1 / wholesale markup.

The same calculations can be used to determine your average wholesale markup.  The average whole markup would be equal to 1 / gross margin.

Related Posts:

1. Wholesale Markup versus Profit Margin

Wholesale Price of Item + Markup = Retail Price

Retail Price – Wholesale Price of Item = Profit

Wholesale markup is the amount you add to the wholesale price of an item to calculate the item’s retail price, expressed as a percentage of the item’s wholesale price.  The wholesale markup tells us how much we add to the price of the item to calculate the retail price.  So wholesale markup = $ amount of markup / Wholesale Price of Item.  If an items costs $5 and we mark it up $7.50 the wholesale markup is 150% ($7.50 / $5.00).

Profit margin is the amount you make off the sale of the item, expressed as a percentage of the retail price.  The profit margin tells us how much of the retail price is profit.  So profit margin = Profit / Retail Price.  If we sold an item for $12.50 and the profit from the sale is $7.50, then the profit margin is 60% ($7.5 / $12.50).

If we used our profit margin instead of the wholesale martup to calculate our retail price we could be in trouble, even cause our business to lose money in the long run.  All of our business’s operating expenses, including our salaries, are paid out of the profit from product sales.  Lets assume you need a 150% wholesale markup  so you have enough profits to pay your operating expenses and yourself.  But instead of using your wholesale markup to calculate our retail price you use your profit margin.  The product costs $5.00.  You markup it up 60% or $3.00.  This makes the retail price $8.00.  You  make only $3.00 per sale instead of the $7.50 you need.  You end up losing your salary and hoping you have enough to cover the rest of your operating expenses.

Related Posts:

1. Cost of Goods Sold, Gross Profit, and Gross Margin

Work from home – No need to set the alarm to go off in the morning.  No more hour long commutes to get to work.  No more cramped work spaces or annoying co-workers.  You have a more relaxed and comfortable work space. You can go to work in shorts or your pajamas if you like.

Flexible work hours – Work when you want to.  You decide how much or how little you are going to work.  You decide which holidays to take off and when to take a vacation.

Satisfaction of being your own boss – You’re now in charge.  No one else is going to tell you what to do.  You get the satisfaction of making your own decisions and expressing your own ideas.

Creative freedom – You have the freedom to express your own creativity.  You can show your creative side through your work and how your present yourself online.  You can show who you really are.

Can operate from anywhere – You’re not limited by a physical store front or office building.  Since the business is online you can operate for anyplace you can get a internet connect.  All the tools you need are available online as well.

Start small – You can start out small, then expand as your business grows.  Many small business can be started with just a laptop and an internet connection.  There is no need to invest $1,000s in inventory.  Use a company like World Wide Brands to find a few items you want to sell and auctions them on eBay, drop shipping the items to the highest bidder.

Inexpensive to start and maintain – Contrary to what many people think, starting a small business online is very affordable.  You can get started for as little as $10.  There are a great many free tools and resources available online to help you run your business.  You can find web hosting for as little as $5 a month.  A good web host like Blue Host makes setting up your blog or web store very easy.

Addition income source – When you’re first starting out your online business can be a nice supplement to your monthly income.  As the business grows you may be able to replace your traditional job.

Unlimited income potential – There are literally millions of ways your business can make money online.  Any one of them can be a good source of income.  But online you are not limited to just one or two or, even, a few ways to make money.  You can make money from as many ways as you like, giving you unlimited income potential.  Auction stuff on eBay.  Open an online store, or two, or three.  Create several affiliate marketing site.  Start a blog.  You’re only limited only by your imagination.

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Getting legal is not difficult and every business that wants to be successful needs to do it.  The basic for forming a legal (retail) business in the U.S. is listed below.  The actually requirements will vary from state to state.  Check with your city, county, and state offices for the exact requirements where you live.  I will provide links to additional resources as I can.  Each step should be done in the order listed.  Later steps will require information obtained in earlier steps.

1.    Get an Employer Identification Number (EIN) – An EIN is also known as a federal tax identification number, and is used to identify a business entity that is legally separate from yourself.  Getting an EIN is optional for a sole proprietorships and general partnerships unless they have employees.  An EIN is required for all other business structures.

U.S. Internal Revenue Service
Phone: 1-800-829-4933

• Guide to the Employer Identification Number
• Apply for an EIN Online

2.    Register for a State Employer Identification Number (SEIN) – If you have or are going to have any employees you must obtain a SEIN.  Getting a SEIN is optional for a sole proprietorships and general partnerships unless they have employees.

• In California: Am I Require to Register as an Employer

3.    Register Fictitious Business Name – If your business name is not your own personal name, it’s referred to as an assumed, or fictitious, name.  Registrations of this kind may also be known as a DBA, or “Doing Business As.”  Depending on where you live, this registration can be obtained from a state agency or a city or county clerk’s office.

• Business Name Registration

4.    Get a Seller’s Permit – This is also known as a Use Tax Permit or Certificate.  This permit authorizes you to collect sales on taxable items sold in your store.  A seller’s permit is required for you to legally resell any item purchased from a wholesale supplier.  Also, the wholesaler cannot legally sell you any business without a seller’s permit.

If you are drop shipping then a seller’s permit may be required in each state the wholesale drop shipper has a physical presence.  Ask the wholesaler where their warehouses are located and about their sale tax requirements.  Also check with each state where a warehouse is located.

5.    Open a Business Bank Account – You need to keep your business and personal asset separate.  If you use a single bank account for your personal and business finances then the IRS cannot tell which transactions are which and you may be subject to some hefty fines and penalties.  You must have a separate business account.  All business transactions are done through the business account.  Personal transactions are done through your person account.  This is especially important if you have a limited liability business structure.  You will lose your limited liability status if your business and personal assets are not kept separate.  If you plan to accept credit card payments from your customers you need to have a business bank account.

6.    Open a Merchant Account – If your online store is going to accept credit card payments then you need a merchant account.  When someone buys an item from you store and pays with a credit card, the credit card transaction is processed through your merchant account.  The merchant account will verify the customer’s identity, collect the money from their credit card company, and deposit the money, minus a small fee, into your bank account.

Getting your business legal may seem overwhelming at first but is actually quite simple and well worth the time.  Getting legal also allows you buy from wholesale suppliers which gives you access to many more products at lower prices then you are aready paying.

Here are some great additional resources for anyone wanting to start their own business:

• Business.Gov
• California Tax Service Center
• Starting Your Internet Business Right
• Free Product Sourcing Video Course

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Sole proprietorship

A sole proprietorship is an individual person engaged in a trade or business.  The business is owned by the individual who takes full responsibility (and risk) for the day to day operation of the business.  The business may or may not have any employees, but the still has full responsibility.

Advantages – Proprietorship’s are easy to set up usually only requiring fictitious name certificate and, if you are a reseller, a sales tax permit.  The sales tax permit allows the business to collect sales tax in the state where the business is located.  A fictitious business name certificate may also be called business license or DBA certificate (Doing Business As).  You usually do not need a fictitious name certificate if you are doing business under your own name.  Taxes are relatively easy.  You fill out Schedule C to deduct your business expenses from your income taxes.

Disadvantages – Taxes are paid at your individual tax rates.  Individual tax rates are typically higher than business tax rates so you may end up paying more taxes.  The owner of a sole proprietorship has unlimited liability for every business mistake.

General partnership

A general partnership is formed when two or more “sole proprietors” decide to pool their resources and share profits and loses from the business.  The key factor that makes the business a partnership is that the profits and loses are shared.

Advantages – General partnerships are easy to set up.  You don’t need a formal written partnership agreement, a simple  “gentleman’s agreement” is usually enough.  A detailed partnership agreement is highly recommended.  The agreement should specify how the profits and loses are shared and how conflicts between the partners are supposed to be handled.  Taxes are easy.  The partnership files an information return on Form 1065.  Each partner pays taxes on their “pro rata share” of the profits at their individual tax rates.

Disadvantages – Taxes are paid at your individual tax rates.  All partners have unlimited liability for every business mistake.  If partner A hurts someone while on partnership business, all partners are liable even though they were not involved.  Partnerships have what is called a “phantom income” problem.  This is when the partners have to pay taxes on their “pro rata share” of the partnership’s profits even though the partnership did not pay them cash to cover the taxes.

Limited partnership

A limited partnership is a partnership with two classes (or tiers) of partners:  general partners who have unlimited liability for the actions of the partnership and “limited partners” who are liable only up to the cash value they’ve contributed to the partnership.  Limited partners are also sometimes known as “silent partners”.  The key distinction between general and limited partners is that general partners are responsible for the management and operation of the partnership.  Limited partners cannot participate in the management or operation of the partnership.  If they do then they are considered general partners and lose their limited liability status.

Advantages – Only general partners have unlimited liability.  Limited partnerships also have the same advantages as a general partnership.

Disadvantages – Limited partners cannot participate in the management and operation of the partnership without becoming general partners.  Limited partnerships are more complex, requiring additional paperwork to maintain the business structure.  Limited partnerships also have the same disadvantages as a general partnership.

“C” corporation

A corporation is a separate legal and taxable entity from its owners, or shareholder.  It’s called a “C” corporation because it is taxed under Subchapter C of the Internal Revenue Code.  Corporations issue shares which represent a part ownership in the corporation.  Directors and officers are chosen to oversee operations and manage the corporation.

Advantages – The shareholders of a corporation on liable only up to the amount of their individual contributions as capital to the corporation.  The shareholder’s personal assets are protected from liability by the corporation.  Corporate tax rates are typically less than individual tax rates.

Disadvantages- Corporations can be expensive to form often requiring the help of an experienced attorney.  Start up legal expenses and filing fees can easily reach $1,000 or more.  A corporation may have to register as a “foreign corporation” in all states, other than its home state, in which the corporation has a physical presence.  Corporations can be expensive to keep alive.  Each state has specific reporting and documentation requirements that must be met for the corporation to maintain its legal status.  Some states also require a minimum tax payment from the corporation whether the corporation makes any money or not.  California requires a minimum tax payment of $800 per calendar year for corporations.  If you don’t use and treat the corporation with respect the corporation could lose its limited liability protection allowing others who sue the corporation access to your assets as well as the corporation’s assets.  This is called “piercing the corporate veil”.  Corporations require a lot of paperwork.  When you have a corporation, you don’t do anything; the corporation does everything.  For a corporation to do anything the shareholders have to prepare written documents (called resolutions or “minutes”) authorizing the directors of the corporation to do the thing, and the directors have to prepare written documents authorizing the officers of the corporation to do the thing.  Corporate dividends are double taxed.  The corporations pays taxes on all of its profits.  The corporation may distribute a portion of the after tax profits to its shareholders as a dividends.  The shareholders receive their dividend but must pay personal income taxes on the amount received.  A “C” corporation typically requires three or more individual and separate directors and officers to manage the corporation.  An individual may be both a director and an officer and may hold more than one office within the corporation at the same time (such as CEO and COO) as long there are at least three directors and offices held by separate individuals.

“S” corporation

Also known as a “Subchapter S corporation”.  A “S” corporation is the same as a “C” corporation except that it is not taxed by the federal government.  The shareholders are taxed like a general partnership while enjoying the limited liability of a corporation.  “S” corporations issue shares just like “C” corporations.  The shareholder’s pro rata portion of shares are used to determine the shareholder’s portion of taxable profits.

Advantages – In some states a “S” corporation can be formed by a single individual.  “S” corporations have the same advantages as “C” corporations.

Disadvantages- Some states and cities do not recognize “S” corporations so the corporation may be subject to double taxation at the state or local level.  “S” corporations have the same “phantom income” problem as general partnerships.  There are a lot of extra rules a “S” corporation must follow to not be taxed as a “C” corporation.  “S” corporations have different IRS reporting requirements than “C” corporations and must report certain items of income differently.  It can be difficult to operate a “S” corporation without a good accountant.

Limited liability company (LLC)

A limited liability company is basically a “S” corporation without the many rules that make them unattractive to many business owners.

Advantages – Owners of LLCs have limited liability.  LLCs are easy to run.  There is no need to prepare minutes or resolutions to authorize people to do things;  they just do them.  LLCs are tax like a partnership.  Overseas companies are more familiar with LLC style companies.  So being an LLC may give the company and advantage in overseas markets.

Disadvantages- LLCs have the same “phantom income” problem as partnerships.  There are restriction on what an LLC can and cannot do if it has employees.  Many investors view LLCs are small time business so may avoid LLCs that are trying to raise capital.  Some cities has burdensome requirements for LLC making doing business difficult.  Some states have minimum tax requirements for LLCs.  California requires a minimum tax payment of $800 per calendar year for LLCs.

Limited liability partnerships (LLPs)

An LLP is a general partnership where the partners have limited liability for the acts and omissions of the other LLP partners.  LLP partners also have limited liability for the contracts they sign on behalf of the LLP.

Advantages – LLPs have the same advantages as general partnerships.

Disadvantages- LLPs have the same disadvantages as general partnerships.

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• What the Times-NYU partnership says about the future of journalism education: A Q&A with Jay Rosen » Nieman Journalism Lab
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• 3 Strong Reasons Smart Entrepreneurs Hate To Operate A Sole Proprietorship Kind Of Business. | How To Start And Build A Successful Business From Scratch.
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