E-Commerce Accounting 101: Tips, Tricks, and Mistakes to Avoid
Episode Summary
In this episode of The Free to Grow CFO Podcast, Jon Blair sits down with AJ Stockwell, founder of Climb CFO and e-commerce accounting expert, to tackle one of the biggest challenges DTC brand founders face: keeping clean, accurate financials. Together, they dive into the essentials of bookkeeping for e-commerce brands, from spotting red flags to optimizing margins and ensuring financial clarity. Jon and AJ highlight a critical yet often overlooked mistakeâmisclassifying sales tax as revenue or expenses on the P&L statement. As AJ explains, sales tax is actually a liability, and including it on the P&L can seriously distort your brandâs financial health, impacting decisions around pricing, ad spend, and growth strategy. This episode is packed with insights to help founders maintain accurate records that drive smarter decisions.
Topics Covered in Episode:
Biggest Red Flags in DTC Financials: Common errors in e-commerce bookkeeping that signal trouble.
Holiday Cash Flow Management: Why Decemberâs slower sales and post-holiday tax liabilities require extra planning.
Landed Cost Accounting: Why itâs challenging for DTC brands and how to stay ahead with smart tracking of freight, duties, and fees.
Episode Links
Jon Blair - https://www.linkedin.com/in/jonathon-albert-blair/
AJ Stockwell- https://www.linkedin.com/in/ajstockwell/
Free to Grow CFO - https://freetogrowcfo.com/
Climb CFO - https://climbcfo.com/
Meet AJ Stockwell
AJ Stockwell spent a decade as the CFO and Controller of numerous e-commerce brands, both in-house and on a fractional basis through his firm Climb CFO. More recently, he has shifted his firm's focus to accounting education and helping businesses clean up their books rather than providing ongoing CFO support.
Transcript
~~~
00:00 Introduction
03:50 AJ Stockwellâs background
05:51 The Importance of Accurate Bookkeeping
12:01 Red Flags in Financial Statements
30:22 Navigating Financial Complexity in E-Commerce
36:43 The Importance of Accurate Costing Methods
39:45 The Challenges of Landed Cost Accounting
45:27 The Significance of Contribution Margin in Profitability
50:21 Closing Thoughts
Jon Blair (00:00)
Yo yo, what's happening everyone? Welcome back to another episode of the Free to Grow CFO podcast where we dive deep into conversations about scaling a DTC brand with a profit-focused mindset. I'm your host, Jon Blair, founder of Free to Grow CFO. We're the go-to outsource finance and accounting firm for eight and nine-figure DTC brands. All right, today, I gotta be honest, my guests, this is a long time coming, because this is one of my good buddies, and actually, to be quite frank,
He's someone who took a lot of phone calls from me the year leading up to starting Free to Grow CFO. He was kind of a sounding board of like AJ, should I do it? Should I not do it? And so AJ is actually like a super important person in the history of Free to Grow, whether you know it or not. So AJ, thanks for joining, man. I appreciate having you here. How you doing today?
AJ Stockwell (00:53)
I'm doing great, yeah, and it's awesome to be on here finally. I know we've been trying to make this happen, so I'm excited to record this and hopefully it's not the last time.
Jon Blair (01:03)
Yeah, 100%. So here's actually a little bit of history about how I know AJ. And he's gonna give his own background in a second, but AJ was formerly the controller of one of the early e-comm brands, Tuft & Needle. If you're an e-comm nerd, you've definitely heard of Tuft & Needle, probably heard a little bit about their story. AJ ran all kinds of stuff on accounting and finance for them as they were scaling super fast. At Guardian, we had hired a few people from Tuft & Needle, kind of post the merger that they had with SSB, and we were introduced to AJ through a former Tuft & Needle employee who was working at Guardian. AJ actually worked for us as a fractional CFO and controller for a period of time. That's where we met, but we stayed in touch after we kind of took those functions fully in-house.
And as I was wrestling with the idea of starting Free to Grow CFO, knew AJ was a perfect person to call, one, because we could have nerdy accounting conversations and both enjoy it. But two, he had started Climb CFO, which at the time was a firm that was focused on serving growing e-commerce brands as well. And so today we're gonna be talking about e-commerce accounting, tips, tricks. do's and don'ts. Super important topic and I couldn't think of anyone better to have on than AJ. The reason we're talking about this is because we just keep seeing time and time again when we come across brands who are interested in potentially working with Free to Grow that they don't even realize how messed up their accounting is. Oftentimes they'll have a sense that something's wrong because they'll look at the numbers and something doesn't seem right. Most founders have a picture in their head of where they think profitability is gonna land for a given month and then they get the P&L from their bookkeeper and they're like dude this is way off from what I was expecting. What is going on? Well, we're gonna actually dive into some of the most common issues and red flags that we come across That are probably driving your inaccurate bookkeeping. So what this is gonna do is it's gonna equip you as a founder to be able to Identify that you do indeed have a bookkeeping problem Where it's probably coming from?
And then which is gonna better inform you to know how to kind of decide on the next steps to go find the right person or people to help you get it fixed so that you can ultimately make timely and quality decisions based on your bookkeeping. So before we get into the details of all this fun stuff, AJ, if you could give the audience kind of a quick rundown of your background and your journey to where you're at today at Climb CFO.
AJ Stockwell (03:54)
Great. Yeah. So as you mentioned, I was previously with Tuft & Needle. I was their first accounting and finance hire a little over a decade now ago, which is pretty crazy to think about. There were about nine or 10 of us at the company then. And that year we did about nine million in revenue. Over the next four years, I helped grow the brand, helped build out the accounting and finance function as the company grew.
And then about four years after I joined, we completed a merger with Serta Simmons Bedding. And that was the time that I kind of ended up leaving the company. So those were really nice bookends, you know, being the first accounting and finance hire and then seeing it through that merger. And at that point, you know, the brand had well over a hundred employees and, you know, north of 150 million in revenue that year. So really.
astonishing growth, not something that I've personally honestly been involved in much or seen since Tuft & Needle. So it was a really incredible learning and growth experience for me. And then by the time I was getting ready to leave Tuft & Needle, I'd already been thinking about leaving the company for a little while just because I recognized that I liked working with earlier stage brands and working with smaller teams.
You know, my time at Tuft & Needle was kind of consumed with meetings and managerial roles and I liked to, you know, be kind of more boots on the ground helping grow a brand. And then the second thing that I recognized was that there was a real need out there for e-commerce brands, especially, you know, we're talking about 2018 or so now when e-commerce was really exploding.
And there was a great need for a higher level of accounting and finance guidance by brands who maybe weren't big enough where it would make sense for them to have a full-time CFO, but they still really needed a lot of the discipline and structure and kind of higher level guidance that comes from a CFO. So that's when I recognized the opportunity to start Climb CFO and start working with brands on a more dedicated but fractional CFO basis. And then more recently in the past year, I've actually sort of wound down the CFO practice and focused on sort of smaller scale projects and advising, especially around helping companies clean up their books and clean up their financial statements, which I know is kind of the big topic for us today. So it's perfect.
Jon Blair (06:43)
For sure. Well yeah, okay, so a couple things I want to kind of draw here. One, if you kind of read between the lines, AJ saw growth from nine million to very healthy nine figure revenue in four years, right? So like a lot of lessons learned there that a lot of people don't have not learned firsthand before themselves, right? And then two, I always say this, you as an e-comm brand need a CFO before you can afford one full time. That's something that we've realized that free to grow is a reality. And the good news is you don't need one full time before you can afford one full time. And today with firms like free to grow and others out there in the space that are able to provide CFO services on a fractional basis, it allows you to get the CFO expertise that you need to scale your brand profitably and with healthy cash flow, but at a price you can afford today, right? And so, you can, now that you've heard AJ's background, you've...
probably recognize why it made so much sense for me to pick his brain before we started Free to Grow because he was a few years ahead of me in you know starting a practice in kind of the same areas. But yeah, what we're going to talk about is we're going to talk about messy books, why clean books are so important and what it means for you as the founder if you're dealing with messy books and the potential like, you know, real big issues that it could cause for you. the first question I have, I touched on this a little bit in the intro, but from your perspective, AJ, why should brand founders care about accurate bookkeeping?
AJ Stockwell (08:39)
Yeah, so I think the list there is sort of endless. A couple of just like surface level sort of obvious things are, you know, from a compliance and reporting perspective, you know, making sure that you're getting your taxes filed correctly and accurately is crucial. And then from a financial reporting perspective, you know, if you're reporting to a board or investors or any external parties, you know, it becomes crucial to have
Jon Blair (08:44)
Hahaha
AJ Stockwell (09:09)
accurate numbers that make sense. And then, you know, nevermind if you're going to look for an acquisition or starting to raise money, they become even more crucial in those cases. But probably the most important and kind of the core of it is just being able to operate your business on a day-to-day basis, knowing what's actually going on, you know, having a clear windshield and seeing
what's going on in your business, understanding the health and the performance of your business on a day-to-day, month-to-month, year-to-year basis, and having confidence in those numbers. it sort of eliminates a huge unknown that shouldn't be an unknown when you're starting to have certain strategic conversations around whether it's a large investment in a new product line, into a retail store things like that or an infinite number of potential strategic directions that you might go.
Jon Blair (10:15)
Yeah, I love the analogy of the clear windshield. Like if you got a windshield that's got mud all over it, like how can you drive the car safely, right? And the other thing that I want to mention is that by virtue of running a DTC brand, you have chosen one of the more challenging verticals to scale within. Why? One, there's a ton of competition. Right? And there's more competition today than there's ever been because the barrier is super low to entry. Anyone can buy products, source products off Alibaba, fire up a Shopify store, start spending money on ads. So there is very low barrier to entry, which is one of the reasons there's so much competition. But just looking at the business model, you have a business that is largely driven by ad spend, which is a huge investment, and you hold inventory which represents another like complexity of the business and use of cash. And so, we always say like the reason, every vertical has a need for clean books. But I would say that some of the simpler business models can get by without clean books right, for a while, eventually they're still gonna need them once they get to a certain size. But in e-comm, you need them a lot sooner than other verticals because you're dealing with heavy amounts of ad spend and you're dealing with inventory, which makes things that much more complicated, which means there's actually more metrics and KPIs that help you understand financial health that you need to track than some other simpler business model. next we're gonna get into talking about some of the biggest red flags that we see over and over again. These are red flags that indicate like, hey, almost guaranteed there's a big issue with the books here. And because there's a big issue with the books, they're presenting information that is probably misleading when it comes to making operating decisions in your business. So let's chat first about sales tax. Because I actually see...
I run all the sales in Free to Grow and so I actually review the financials of every brand that we create a proposal for. And I actually see this more frequently than anything else in terms of red flags. There's some issue with sales tax that ultimately means there's an issue with revenue.
From your standpoint, what are some of the common things that you see on your end when you come across books and you notice there's a sales tax issue and what does that mean for the accuracy of those books?
AJ Stockwell (12:59)
Yep, yeah, so I agree with you that it's one of the top red flags and one of the first things to look for just because it can be so obvious. once I see it, it's a sign that, you know, this this review is going down a little bit different of a path and it's becoming, you know, more complex and I'm going to spend more time understanding what's going on with the company's books. The bottom line, and this is why it's so easy to kind of see.
Jon Blair (13:15)
Yeah.
AJ Stockwell (13:28)
The bottom line is that sales tax should not be anywhere on the P&L statement because sales tax is not an income when you're collecting it from customers. It's not an expense that you're paying out. It's not your tax. What it is is a liability and it's something that, you know, a company is just holding kind of on behalf of a tax agency. So that's why it's a liability.
because customers truly are the ones paying the tax. It's part of their cost and businesses have a responsibility basically to collect and then remit that tax to the taxing agencies. So anytime I see sales tax income as an income row, I know that there's a red flag. And if I see it also separately or in addition,
Jon Blair (14:17)
Ugh.
AJ Stockwell (14:26)
as an expense going out. That's kind of the second red flag. And those are probably the two most common places where I see it and it jumps out right away like a sore thumb. One of the, I guess, like quick, you know, deeper reasons why this can be an issue and not to get too far ahead of ourselves. But if you're reporting the sales tax that you collect as income,
Jon Blair (14:40)
Yeah.
AJ Stockwell (14:54)
and then the payments as an expense, then not only are you showing them incorrectly and maybe there's an argument that it's netting out in the bottom line of the P&L, but the much bigger issue is you're overstating your revenue. So you're looking at your financial statements thinking you're taking in more revenue than you actually are. And then if that expense is
Jon Blair (15:06)
hear that a lot.
AJ Stockwell (15:22)
lower on the P&L within the operating expenses or something like that, then that means that you're also gonna be overstating your gross profit margins. And you're gonna be thinking that your products themselves are more profitable than they actually are because you have this revenue overstated.
Jon Blair (15:32)
Mm, yep.
Yeah, so another way to think about this is...
you know, your margin ratios, right? So if we take gross profit margin ratio or gross profit margin like AJ was just talking about is you've got gross profit dollars divided by revenue dollars, right? Well, you're overstating revenue. So you're actually you're throwing your understanding of your margin ratios gets completely thrown off. If there's anything in your financials. And this is common. Most founders have some number of metrics that they divide into revenue, right? To get the margin
ratio and if the denominator is revenue and revenue is overstated because sales tax is in there, then that ratio is wrong, which means what? It means misleading data that may lead you to make bad decisions, right? And let's take it even one step further. What's the margin? What's the number one reason why I hear
DTC brand founders wanting to understand their margin ratios because they want to know how much they can afford to spend on advertising, right? Because what percentage of every revenue dollar is available to spend on advertising and then hopefully still have some left over to cover fixed overhead? Well, guess what? If you're calculating the wrong percentage because the denominator in those ratios is wrong because you've your overstating revenue by including sales tax,
AJ Stockwell (16:49)
Right.
Jon Blair (17:09)
you're making bad ad spend decisions that you may think are profitable and aren't or vice versa. And you don't want to be doing that because as you're scaling, you know, to seven figures and then to eight figures and then to nine figures, you're spending more and more ad dollars. And you want to know for sure with certainty, with confidence, what the impact is of those advertising dollars on the business's profitability. There's one other thing I wanted to note.
that you mentioned AJ is like, I hear a lot too. well, they just net each other out. Well, here's the reality. That's not maybe they net each other out in aggregate, right? And when I say like over a long period of time.
But the reality is we don't work with a brand who doesn't have different filing frequencies for different states, right? Like, and it depends on thresholds. Like, can start annually and then once you start collecting more, goes to quarterly and then it goes to monthly. Yeah, well, if you collect every single day and that hits your revenue, but you don't pay it out until three months later because you're a quarterly filer, it doesn't net each other. They don't net each other out on those three months leading up to when you finally pay it out. So like,
That's a slippery slope argument to try to hang your hat on. But here's another thing that I wanna dive into with you. And this one is actually the one AJ started with, which is sales tax collected as revenue, sales tax paid as an expense. That at least has.
AJ Stockwell (18:29)
Yeah.
Jon Blair (18:41)
You can identify that, you can see those things, right, in the chart of accounts and on the P&L. But there's this other one that's maybe like a little bit more, even a little more dangerous, which is you don't see sales tax anywhere. It's not on the P&L and it's not on the balance sheet. And what are some reasons that you, when you see that AJ, what does that start leading you to think may be going on?
AJ Stockwell (18:55)
rate.
Yeah, so there are usually two possibilities there. One is that the company is just outright reporting on a cash basis, whether it's just for the revenue of that portion alone or for all of their business. And I know we're going to talk about inventory as well. But one thing that that can show is the company is just reporting revenue on a cash basis, which most commonly what that will look like is
Jon Blair (19:18)
Mmm.
AJ Stockwell (19:35)
you know, in their bank feed, a deposit from Shopify comes through and they just post that to sales. But the problem there, of course, is that, you know, there's sales tax in there. There's there are, you know, fees probably taken out of it that they want to get broken out and things like that. So that's one. And that's probably the most.
Jon Blair (19:45)
Yeah.
AJ Stockwell (19:59)
dangerous in a sense. It's again kind of easy to recognize if you just look at the entries that are, you know, posting to the overall sales account on the P&L because you'll see that it's just those those deposits from the merchant processor. And then the second one is that maybe people are breaking out the way that they're entering their revenue and their transfers that are coming from their merchant processor.
but they're still just posting those sales straight into that main revenue account on the P&L. So anytime I'm looking at the P&L and looking at, I'm clicking into revenue and looking at the detail of that ledger to see how this is actually being posted.
Jon Blair (20:35)
Yeah. Yeah.
For sure, yeah, this is the second most common thing we see. And usually what we find is it's a CPA firm, a horizontal CPA firm, meaning that they serve like any and all industries. They're tax, they're really tax preparers. They're doing the books. And so they oftentimes are doing the books on a cash basis because it aligns with what, it aligns with the tax return strategy basically. But you know, the problem is again, going back to margins, the most common version I see,
is the first one that AJ walked through, which is that when you get a net payout that comes from Shopify every day or every couple days, that net amount that hits your bank account, they just post that straight to a single revenue general ledger account. The issue is it includes, it's actually inclusive of gross revenue, discounts, refunds, sales tax payable, and merchant processing or credit card fees. But even worse,
there's a delay between the sales, the actual orders and sales associated with those amounts. And so they may not even be posting it in the right month. A perfect example is like on, know, actually upcoming, where we're gonna see this a lot in our CFO audits is after this holiday season because Black Friday, Cyber Monday this year crosses over from November to December. So what that means is all these brands are gonna have a huge concentration of sales and incoming cash being generated
AJ Stockwell (21:47)
Yeah.
Jon Blair (22:13)
this last week of November, but a bunch of those Shopify deposits are gonna hit their bank in December. And so if your CPA or your bookkeeper's doing the books in this manner where it's cash basis and it doesn't include that breakout of those different actual P&L line items,
you're gonna see a bunch of revenue from November actually hit in December. There's a whole nother can of worms we could open up on like revenue recognition timing, but the bottom line is it may put your revenue in the wrong period, which can lead to bad decisions. It doesn't actually allow you to understand how much of that quote net revenue. I'm saying quote because it's.
partially wrong, is actually sales tax, is credit card fees, is refunds, is discounts, all of those things. It doesn't matter until it matters. And guess what? Guess when it's gonna matter? Black Friday, Cyber Monday weekend, when you're giving big time discounts, you're collecting a bunch of sales tax, you have a whole bunch of merchant processing fees, you want that stuff recorded right so you actually know how it's impacting your profit and cash flow.
Is there anything else related to this AJ that you see like when the accounting is done this way, like what kind of trouble it can get a founder into in terms of decision making?
AJ Stockwell (23:35)
No, I think just the one step further is, and I know we have inventory on our list, but sort of same thing when you're considering how you're posting your cost of goods and costing out the inventory that you're selling, this cash basis of recording revenue only makes that more difficult and probably further incorrect depending on the way that you are.
Jon Blair (23:58)
Totally.
AJ Stockwell (24:04)
recording your cost of goods and your product costs especially.
Jon Blair (24:06)
Yeah, and because revenue minus cost of goods is gross profit.
You've got revenue from gross profit possibly in one period and cost of goods sold in another one. And so if you look, depending on the time period, you're looking at gross profit. It's wildly over or understated in one period and then corrected, quote, self-corrected and over and understated in the other direction in the next period. One other thing I want to point out, this is something that's probably less common for founders to realize, but you want to make sure the payables.
AJ Stockwell (24:16)
Exactly.
Jon Blair (24:42)
on your balance sheet are accurate every month and sales tax payable being one of those because cash in the bank is not all your cash, right? It can be very misleading. Again, especially after a big sale like right after Black Friday, Cyber Monday, you have all this cash and you're like, bam, there we go, baby. All this cash. But how much of that is due to taxing authorities, right?
AJ Stockwell (25:04)
Yep.
Right.
Jon Blair (25:09)
How much of that is due to your vendors in the form of accounts payable? How much of that is due on your line of credit which you extended to buy all the inventory for that sale weekend? And so I kind of made this metric up. It comes from the metric quick ratio. I call it what's your quick cash balance, meaning like take cash and you subtract your current liability. So your cash on hand and subtract AP, sales tax payable, and then maybe your line of credit.
whatever's due soon, that's the cash you actually own. You back out credit cards too. So you may have a million in the bank and you back out those other items, you only have 200K left over. So don't go on a crazy spending spree. You actually owe some other people money eminently. So that's another reason why you gotta make sure this stuff is accurately split out on the P&L versus the balance sheet.
AJ Stockwell (25:52)
Right.
Right. Yeah. And I actually just want to emphasize that even a little bit further because another common dynamic with Black Friday, Cyber Monday is that a lot of brands will have much slower sales in December, especially when that full weekend is in is actually in November. So what will happen is, you know, someone might be sort of planning their cash and they're just looking at what's in the bank account.
Jon Blair (26:18)
for sure.
AJ Stockwell (26:31)
and they know that they're gonna have lower sales receipts in December, but they might not be thinking about really the impact that those sales tax payments can have on their cash, especially as brands get to be.
Jon Blair (26:45)
Totally.
AJ Stockwell (26:48)
a pretty big size with economic nexus and everything. know, brands are filing sales tax in 20 plus states, know, 20, 30 more states for big brands. And that's a, that ends up being a lot of cash, especially when you go from.
a huge level of sales over the course of a weekend and then end up with a much lower than normal sort of level of sales. It's, when you have when you don't have those monthly fluctuations, it can be a little bit easier to sort of plan or you sort of like expect kind of the level of cash that's going out for those sales tax payments on a month to month basis. But I've seen people kind of underestimate those December payments.
Jon Blair (27:12)
Totally.
AJ Stockwell (27:35)
which can be really considerable.
Jon Blair (27:37)
That's a great point and actually going back to something I said at the beginning which is like hey Newsflash you picked a hard vertical right by getting into ecom You've got to spend a lot of money on ads and understand whether they're profitable or not You got to hold inventory and the third one is you're in consumer goods So there is seasonality like there are yes, there are some consumer goods brands that
that have less seasonality than others, but most of them have some form of seasonality. And so this, what AJ was just talking about, nailing your planning from a cash perspective becomes even more important when you have any sort of seasonal peaks and troughs, which so many consumer brands do. And that's again where getting the help from a CFO who understands these dynamics, is gonna just help you make decisions at just such a higher level of sophistication as you're growing your brand.
AJ Stockwell (28:34)
Yeah, and I think this is also like a really important sort of warning. And I'm just going to even further emphasize it for brands is this cash planning, like December cash planning should start maybe in the summer. I mean, obviously we're always planning, you know, ideally kind of 12 months in advance. But when it comes to the really tactical cash planning for the end of the year, it does need to start a little bit earlier and be a little bit more thoughtful. Because you also brought up things like lines of credit and vendor payables. And so a brand can get really bad whiplash when they come off of the end of Black Friday, Cyber Monday, and they have maybe the highest cash balance that they've had all year. And then it turns out, my line of credit is based on the amount of inventory that I have. And suddenly I sold through a ton of inventory. So now my line of credit availability has gone way down. So I'm actually not necessarily even going to be able to draw back all of that line of credit balance. And then I have some vendor payments for some of those big inventory purchases and those need to go out. And then I have those sales tax payments. And then potentially one more thing is, you know, maybe I'm seeing higher returns in sort of a real time cash basis in December because overall sales are lower, but I'm seeing the returns from that big Black Friday, Cyber Monday weekend. And these are, you know, four or five huge swings in cash that can really reduce a company's cash balance. And if they haven't planned for at least those items, you you can really run into trouble come the end of the year.
Jon Blair (30:40)
Yeah, great points. And again, reason there's such a need for...higher level sophistication in your accounting and finance functions in a growing e-comm brand, it's because of all these moving parts. AJ just did a great job of kind of going through a list of them, but not all businesses have these, but you're gonna have them if you're growing an e-comm brand, and so you need to have the right accounting and finance team to help you navigate them, because they're not going away, unfortunately. And as you grow, there's more and more zeros at the end of each of those items that AJ just went through, so there's more and more at stake.
So what I want to talk about next is inventory. Some of the biggest red flags that we see on a regular basis as it relates to inventory. So the first one I want to ask you about AJ is prepaid slash in transit inventory. It not being on the balance sheet. Why is this a red flag and what kind of issues does it cause?
AJ Stockwell (31:37)
Yeah, so like with the other topics, there are a few things that can be going on and numerous issues that this causes. But it comes back to kind of the core of understanding what is my current inventory position, inclusive of orders that are already out there and especially inventory that's already on its way to me know, if you don't have the prepaid inventory on your books kind of broken out separately and it's all lumped into inventory, or you know that it's coming, so I'm sort of treating prepaid or in transit similarly, just because once it's in transit, usually you'll have the invoice and that's kind of going into inventory.
You can get into issues if you're managing or looking at your cost of goods sold based on kind of your physical inventory on hand because if I just have one inventory row on my balance sheet and I'm asking my 3PL at the end of the month, what do you have on hand and I'm maybe adjusting my inventory to that or I'm using that to figure out what my cost of goods is then I'm gonna kind of overcorrect or go way too far in terms of what I'm costing out. And then maybe the next month, once they've actually received that inventory that I wrote off or costed out the prior month, all of a sudden it's looking like my cost of goods is higher. I didn't sell as many units, even though we have our sales numbers. So I think it again comes back to sort of the month to month fluctuations and items being posted in the wrong month but also just not having an accurate overall picture of where I stand with all the inventory that I own.
Jon Blair (33:29)
Dude, we see this so often and usually, I would say honestly 99 % of the time, it could even be 100 potentially. Matt Fowler, one of our accounting managers would probably be like, Jon, it's 100 % of the time, I don't know what you're saying, 99% there is no distinction between prepaid and in transit and on hand on the balance sheet. There's usually just like an inventory account. And if there's multiple, it's usually by product category, shirts, socks, hats, whatever, right? But to say what AJ just said in different words, if you don't have them broken out, you can't reconcile the general ledger balance to a physical count. Why? Because the general ledger balance, if it's all lumped into one inventory account, it includes prepaid in transit inventory and on hand. What's the problem with that? Prepaid and in transit will not be in the physical count that comes from your warehouse. So you're gonna compare apples to oranges, right? And when you go to true them up, on the financials, true up your balance sheet to the physical count, everything that was in prepaid and in transit and reality but lumped into that balance sheet balance, that all goes straight to cost of goods sold. But guess what? When it arrives the next month, it'll get subtracted from cost of goods sold. So cost of goods sold is too high one month and too low in another. And it's just, it causes a whole bunch of issues. But furthermore, the other issue is, what we see, this is more of an operational side effect, but it's super important, is that when we see that when brands don't have to track this for accounting purposes, they just don't track it period. So they don't even have an accurate accounting somewhere of what has been prepaid for and what is in transit, which is like a massive miss on just overall operational control to make sure that like you're getting from your vendor what you have prepaid for and to make sure that what is in transit fully arrives, right? And so we almost always, I think close to if not 100 % of the time are setting up a prepaid and in transit inventory bucket for the first time in most of our clients like history and
AJ Stockwell (35:36)
Right.
Jon Blair (35:50)
Usually to be honest with you if you guys end up if you're listening this you end up working with us and you're like my gosh, we don't have prepaid in transit inventory and my margins are all over the place I think this could be part of the problem. Keep in mind. We will not nail correcting it for you in month one unless you have a very detailed accurate historical tracking of prepaid inventory and in transit, which you probably don't and I don't blame you because no one's ever asked you to do it before and you haven't known why it's so important and what's at stake. So usually takes us two to three months. We try to help, we try to go back in the general ledger and look at all purchases that have hit the general ledger, whether it on a cash basis or an accrual basis, we'll try to go back many months, as far back as you think you have something prepaid or in transit, and we'll try to build out, we'll give you a list of things to choose from that's still outstanding.
But even then it takes usually several months to get this nailed down and it basically starts working when you figure out how to track this internally. So just know that like your accountant can't do everything for you historically in terms of cleaning stuff up. And this is one thing that usually takes a couple months to figure out and it's in partnership between who's doing your accounting and who's actually managing your inventory. So another thing that we see on the inventory side of things, well actually hold on, one other thing that I would love to get your take on. So let's just say we kind of take the corollary approach to this and we say, okay, we don't want to break out prepaid and in transit inventory, but we're also never gonna true up the balance sheet to the warehouse and we're just gonna expense to cost of goods sold our estimated product cost by SKU. Because we see that a lot.
What issues does that cause in your mind?
AJ Stockwell (37:43)
So in that case, I think the issue is that you're using estimates there. So you're sort of focused on a P&L approach, which again is common for when you have like a CPA firm, you know, like a tax firm kind of doing the books on kind of a cash basis, they might try to sort of estimate your actual sales, but they would be using an estimate often and that's a focus on the P&L and you sort of run into like a confirmation bias, I guess, because you've sort of decided in your mind and it's of course informed based on historical costs and that kind of thing. You kind of decided in your mind what the P&L amount should be for that cost of goods sold, but you're not looking on a regular basis at the true amount.
Jon Blair (38:13)
Mm-hmm.
Yeah.
AJ Stockwell (38:42)
And the only way to do that is to have a handle on your comprehensive current inventory position, meaning including what's been prepaid and what's in transit. And ideally also kind of breaking things out, not necessarily in QuickBooks, but somewhere by location. one thing like you mentioned, operational danger from sort of an internal controls perspective, making sure that you get what you paid for. But there's also operational danger in the supply chain team not knowing what is coming. And if you're not tracking your in transits well or prepaid as well, then you can end up double ordering for certain items and overbuying inventory so not to go too far on a tangent, but I guess coming back to kind of the P&L focus part, you know, if you're using incorrect estimates, then your balance sheet inventory is just going to perpetually either get higher and higher and higher if your cost of goods estimate is low or your inventory is going to perpetually get lower and lower and lower. And what I mean by higher or lower is
Jon Blair (39:35)
No, no, no.
AJ Stockwell (40:01)
not just from the dollar perspective, but the error is going to be magnified on a monthly basis, either higher or lower. And it becomes a serious headache, especially like I've started to work with brands whose accounting firm was focused on this product costs $10. So we're just going to cost out $10 per unit sold according to Shopify and never look at the balance sheet.
And that goes on for a couple of years. And then all of a sudden, you know, you could have hundreds of thousands or even in the millions of an adjustment that has to be made to the inventory. And meanwhile, it comes back to this idea of, you know, knowing where you truly stand, understanding your true profitability from a product and an overall business perspective and, know, making decisions about how much you can spend on marketing and things like that and knowing those correct margins is crucial. And that's why I always say there are sort of two, the process of recording cost of goods is sort of two steps. And it's, if you're using kind of a landed cost, you know, detail or matrix to calculate your cost of goods at first, that's fine. But there's step two, which is crucial, which is confirming the actual inventory balance on the balance sheet.
Jon Blair (41:13)
Mm-hmm.
Totally.
AJ Stockwell (41:30)
because that's what informs if you are using those correct costs.
Jon Blair (41:36)
Yeah, and furthermore too, there's another thing that we see it's an issue all the time, which is that like, we call it internally, we call it the direct method of applying cost because we're directly applying sales volume times product cost, right? As opposed to indirect meaning backing into it, right? From like, just beginning plus purchases minus cogs equals ending. Yeah, exactly. like,
AJ Stockwell (42:02)
like a purely balance sheet. Yes, there's the pure P&L perspective and then pure balance sheet perspective where you say, you know, what did I buy? What did I sell? Or where did I start? What did I buy? What's the ending? And assuming that that's cost of goods sold, right?
Jon Blair (42:11)
Yep.
Yeah, everything else is cogs. Yeah, but the problem with that one is it doesn't tell you anything about why it was higher or lower than you expected. You're just backing into it, right? And so we take a blended... Yeah, it's even worse. Exactly.
AJ Stockwell (42:25)
Right, exactly. And if you're not tracking prepaids and in transits correctly, then you're running into the huge issues we were talking about a few minutes ago.
Jon Blair (42:34)
Totally, totally, yeah. And so like we take a blended approach, which is we start with the P&L method. If you don't have an IMS, right? If you don't have an inventory management system, which a lot of brands in the lower to middle market don't. But like we do the direct method of applying cost based on your estimated landing costs straight to cost of goods sold. And then we look at the general ledger balance and we compare it to the snapshot physical count, right? And we actually, if we do make an adjustment,
We put that on a different cost of goods sold account so you can see the difference between the true up adjustment, the balance sheet true up adjustment and your directly applied COGS. So you can get a sense for how much each of those entries like really impacted your margin buy.
And furthermore, there are just things that you have to pick up every single month via that balance sheet true up which is like damaged goods, returns that come back in and either get scrapped or get put back into finished goods, marketing samples, things that just go out the door that don't make their way into a Shopify order, right, or into an Amazon order. And so like you have to make sure you account for those, because we've come across brands who have not done that for like four years, and yeah, the adjustment was like 650K, and we're like, hey, unfortunately we can't tell you all the reasons this is so far off. We can tell you theoretically that it's one of or it's probably multiple of reasons within this list of things of and like going forward we're gonna directly apply COGS based on your estimated landed cost by SKU and then we're gonna true up the balance sheet every single month to the physical count so this doesn't happen to you anymore but you know just know that you know I go back to the analogy of like if you're flying a plane right that's supposed to go from LA to New York and you're off on your compass heading by one degree at the beginning you're not veering that far off course, but four to five hours later you may be Heading in a completely different direction and so it's this little one degree off For a long long time all of a sudden puts you super far away from the destination that you were trying to get to and and so just that in mind that like it may not seem like a big deal today but if it goes on unreconciled for one two three four five years you're gonna find yourself way off down the line and the problem is if that results in hundreds of thousands of additional cost of goods sold that's hundreds of thousand dollars of cost that you've had over the last several years that you didn't think you had that you actually have and so the question is what decisions would you have made differently
AJ Stockwell (45:22)
Right?
Jon Blair (45:27)
if you knew about those costs. So there is a lot at stake here. There's one other thing. go ahead.
AJ Stockwell (45:32)
And I would say, I was gonna say these are also issues that get further magnified as you scale and as a brand grows. So again, coming back to the reason that you and I started our firms is just the importance of having accurate financials and understanding where a brand stands, even starting from the earlier stage.
Jon Blair (45:40)
Totally.
So I wanna ask this, we've touched on some things here, but like, what makes landed cost accounting easy in theory? I've got, for those of you watching the video this episode, I'm air quoting, easy in theory, but challenging in practice. There are actually a ton of reasons, but from your perspective, what makes landed cost accounting, accurate landed cost accounting, challenging?
AJ Stockwell (46:27)
So I think it's just the sheer number of sort of different components and the different moving parts to consider. So like one quick thing is, know, freight. Freight is not going to be the same per unit or very rarely gonna be the same on a unit basis for each order or for, and therefore, you know, for each unit that you have. But without.
you know, using a proper inventory management system, which I really believe that companies can get away with using or without using, you know, a really robust inventory management system early on if they have other good kind of processes and checks and balances. But freight is one of those examples of something that's going to fluctuate on pretty much a unit basis. Another tricky thing is, like I was saying, just the number of moving parts. Like you brought up returns. and that's another piece that is technically in transit inventory that people might not be considering when they're closing the books. And, you know, they see these returns in Shopify for, you know, October 31st, but those are not yet put back into inventory. So if we're just doing kind of a simplistic, you know, costing approach,
Jon Blair (47:41)
Mm-hmm.
AJ Stockwell (47:49)
But then also trying to reconcile to a physical inventory count and what we truly have on hand from a balance sheet perspective. There's so many different kind of moving parts that have to be considered that can be really difficult to track without the proper processes.
Jon Blair (48:09)
Totally. Another one is accruing landed costs because so accrual for those of who don't know is an estimate which would like economically from an accounting standpoint economically that either revenue or expense event has actually happens such that it should be recorded, but you don't have an actual transaction maybe or a source document that should drive you to record that transaction. And on landed costs side of the house, what happens all the time, you order something from China, right? It could even be domestically, but like China's a good example because it happens over, you order something, a freight forwarder moves it to the 3PL, it gets received, and on the day it gets received, it gets sold, right?
So it gets sold immediately because you're a low stock on that item. But guess what you haven't gotten yet? You haven't got the duties invoice from US Customs and you haven't gotten the freight forwarder to give you the invoice yet. And even worse, you call the freight forwarder and you're like, I need this invoice because I need to cost this inventory. And they go, hey, all the subcontractors that moved these goods for us, they haven't even billed us yet. So we can't get you the invoice. So what do you do? You actually have to accrue the freight costs as of the day that that stuff got received, right?
you're doing accounting on a monthly basis, there's a period crossover, right, from one month to the next, you at least need to accrue the costs, the estimated costs of the inventory received through the end of that month. And how do you do that? I mean, there are ways to do it. At Guardian, we would use the quote to try to estimate a cost, right? We had a table of duty rates by HTS code where we could get an estimated duties. It's never perfect, but we could accrue costs that are pretty close, right, as of the close of the balance sheet each month, but those are not trivial things to do and there actually is no document. There is no trigger unless you have the process. There's no trigger that says, hey, record this, like a deposit into your bank account or a bill coming in from a vendor. You have to have a process as a part of your month-end closed checklist to check for the need to accrue revenues and expenses and that further complicates landed costs.
All right, so unfortunately we got to land the plane here We're definitely gonna have to have you back to chat some more, but we always like to ask a fun personal question and so before we conclude, what's a little known fact about AJ Stockwell that you think people might find shocking or surprising?
AJ Stockwell (50:40)
I don't know about shocking or surprising. Maybe part of this is, but I really enjoy barbecue. like the craft of, you know, making barbecue and cooking barbecue. it's something that I've been, you know, not to use like a dramatic word, but kind of studying and practicing for the last six or seven years. and then this is a little more maybe surprising or interesting at the beginning of COVID. I actually recorded a series of cooking videos, like instructional cooking videos at my house. And I only did it for a little bit during COVID and you can't find them anywhere. But it's actually something that I've thought about picking back up in terms of recording cooking videos.
Jon Blair (51:26)
Heck yeah, I love that. I mean, I'm in Austin, Texas, so I love barbecue and I've gone on a kind of a little journey myself of learning how to make really, really good barbecue, so I love that. Before we end here, where can people find more information about you and what you were doing today at Climb CFO?
AJ Stockwell (51:29)
Yeah.
Yeah, so you can go to my website, climbcfo.com. It's a pretty simple landing page at this point. But like I was saying, my main focus now is sort of on bookkeeping cleanups and kind of smaller projects. So people can certainly reach out to me at aj@climbcfo.com if they have any interest in talking about something like that.
Jon Blair (52:12)
Perfect, yeah, and depending on who's listening right now and if you end up working with Free to Grow, there's a chance, depending on what your needs are, that you may end up getting connected with AJ through Free to Grow. So it's great to have you on, man. This is such an awesome conversation. Obviously I love that we get to nerd out, but just remember, your bookkeeping matters because it is the foundational, accurate data that you need to make great decisions as you're scaling your brand and scaling an e-commerce brand is one of the hardest things you could possibly choose to do so you gotta make sure your bookkeeping is right because if it is it's gonna make everything else easier on you. Don't forget if you want more helpful tips on scaling profit-focused DTC brand, consider following me, Jon Blair, on LinkedIn. And if you're interested in learning more about how Free to Grow's DTC accountants and fractional CFOs can help your brand increase profit and cash flows you scale, check us out at FreetoGrowCFO.com. And until next time, scale on.
