CEO Owner’s Guide
Updated April, 2016
Since Overstock went public in 2002 we have sought to set a gold standard in candidly communicating your firm's results to you.
As teenagers my brothers and I ran a Christmas tree lot. We cared about reality, not cosmetics, and wanted an accounting system to help us understand and run our business. We devised a system we called, "cigar-box accounting," because at day's end, standing by the trashcan fire, we counted bills in a cigar box and knew what we had made or lost. It was simple, foolproof, and we made good decisions using it.
In our public SEC filings we use GAAP principles, of course (and when there is a choice to be made, I choose principles at the conservative edge of GAAP), but as the CEO of Overstock I use internal methods of accounting that are quite straightforward and generally follow GAAP, but with a few exceptions that I believe better reveal the economics of our business and lead to more informed management decisions. I want shareholders to understand the economics of their business and the metrics we use to manage it effectively, both GAAP and non-GAAP.
Therefore, I describe our GAAP and our internal accounting methods below with particular attention paid to the similarities and differences between the two.
GAAP METRICS - see SEC filings for greater detail
Revenue is comprised of direct revenue, and partner revenue. All revenue amounts are net of returns, chargebacks and fraud, Club O rewards earned (our loyalty program), and sales discounts, primarily coupons.
Direct revenue consists of merchandise sales made to individual consumers and businesses, from inventory we own and fulfill from our warehouses.
Partner revenue consists of merchandise sales made to individual consumers and businesses, from inventory owned by other retailers, distributors or manufacturers, fulfilled either by such suppliers directly or in some cases fulfilled by us from warehouses we operate as a service for our partners. We do not own the merchandise for these transactions unless the product is returned.
Cost of Goods Sold consists primarily of the costs of merchandise sold to customers, fixed warehouse costs, warehouse handling costs, inbound and outbound shipping costs, credit card fees and customer service costs.
Sales and Marketing consists primarily of online and offline advertising, public relations, as well as the costs of our staff engaged in marketing and selling activities.
Technology Expense consist of the costs of our technology staff, technology vendor costs such as licenses, support and maintenance, and depreciation and amortization related to software, computer equipment, and web development projects.
General and Administrative consist of the costs of our merchandising team, analytics, human resources, accounting, legal, and other support staff, audit and legal fees, insurance, rents and utilities, and other general corporate expenses.
Gross Merchandise Sales
One place where we are internally slightly less conservative than GAAP is in how we think of sales. GAAP recognizes as revenue the full value of goods shipped from our warehouses or our partner's warehouses, less discounts and returns, whereas gross merchandise sales ("GMS") is simply the gross amount of goods shipped (and shipping revenue). GAAP revenue is reduced by returns and marketing coupons: in our management accounting system these show up in our COGS and marketing expenses respectively, as explained below.
Cost of Goods Sold
Our accounting for COGS is in-line with GAAP with one exception. Inbound freight, outbound freight, customer service, credit card fees, chargebacks, fraud, and warehouse handling are all included in our management COGS. Unlike GAAP, however, which nets returns from revenue, we include the cost of returns in our COGS calculation, an explanation of which is below.
Economic Cost of Returns - In our early history returns costs fluctuated widely. Stuffing them into a contra against sales both introduced too much noise into many metrics we wished to track as a percent of sales (e.g., “outbound freight as a percent of sales”), and this noise masked them so that sometimes they did not get managed with discipline. As an antidote to this we started thinking in terms of the "economic cost of returns." This calculation, which varies by product, is a function of the percentage of units sold that are returned, the percentage of these that are restocked and resold, the percent that are damaged and so cannot be resold but for which we are reimbursed by either the vendor (for having sent us damaged product) or the freight company (for damaging our product in shipping), handling fees etc. In this fashion we arrive at a "handicap" for each product with which to burden its COGS.
Gross sales less COGS defined as above leaves us the "juice," that is, our marginal gain for making that one additional sale. Juice is comparable to gross profit if you were to subtract coupons, Club O rewards earned, sales discounts, and fixed warehouse costs.
Marketing and Customer Acquisition
Our customer acquisition numbers capture all marketing expenses, from on-line advertising to our off-line branding campaigns to the salaries and benefits of the people in the marketing department.
Marketing Coupons - There was a day when an Internet company would repeatedly give the same customer $5 coupons to buy $15 bags of dog food, and then book the $15 as revenue. Eventually the Financial Accounting Standards Board ("FASB") stopped this practice, opining that a firm could only book as revenue the amount the customer actually paid ($10 in the above example). I agree that the FASB's decision was a step forward, that if I give a $5 discount coupon to the same customer over and over to make such purchases, then she is not really "spending" $15 each time she comes.
Yet there is a different way to look at some coupons: we are sending a check to Yahoo! this month so that they will generate new customers for us, we are sending checks to MSN and Google this month so that they will generate new customers for us, and we are sending a check (in the form of a $5 discount coupon) this month to someone in Peoria in order to be a new customer for us. I agree that at some point if I send the same "check" over and over to the same woman in Peoria to get repeat business from her then ultimately this "check" (i.e., discount coupon) is just revenue I am not collecting. But in general, I think I should treat such cases as marketing checks, just like the checks going to Yahoo!, MSN, and Google, and then calculate the efficacy of such checks, doubling up on winners and cutting losers. Our management accounting therefore does not net them against gross bookings, but instead, treats them as an element of marketing spending.
"Juice" less marketing expenses leaves us the "nectar", or the amount of gross profit left to cover our fixed costs, or "nut" (see below). On a GAAP basis, this is similar to Contribution (Gross profit less Sales and Marketing plus Club O reward and gift card breakage), or Contribution Margin when thinking in terms of percentages.
Another term from my Christmas tree days was "nut" (as in, "Did we cover our nut today?") This includes all employee compensation and benefits (excluding warehouse and customer care staff), warehouse rent and management expenses, corporate and technology expenses, and depreciation and amortization charges. It baffles me that the "pro forma" accounting of some Internet firms excludes depreciation as an expense: either it was an expense the day you bought it, or over the years that you use it up: at some point you have to admit the cash is gone! "Nut" is akin to our Tech and G&A costs under GAAP.
Management Operating Income
With good gross merchandise sales and COGS, and disciplined sales and marketing spend, what is left (nectar) can cover our nut. Anything left after that is management's operating profit. By subtracting any non-cash or other non-operating items from the management operating profit, one gets, as I view it, to GAAP net income.
"Labels are the guests of reality." - Zhuang-ze
What matters in accounting is not always how it is being done, but that the rules by which it is being done are made explicit. As required by law I present our financial results according to GAAP. Beyond that, however, I wish to open our cigar box to you in order to communicate with unprecedented candidness the economics of the business you bought. The system explained above is designed to that end.
Patrick M. Byrne