How Non-VAT Registered UK E-Commerce Businesses Should Think About VAT & Profitability

Paul Grieselhuber

Paul Grieselhuber

Aug 21, 2023

For UK e-commerce businesses that are not yet VAT-registered, it might seem tempting to ignore VAT when calculating profitability and setting prices. However, adopting a forward-looking approach that assumes future VAT registration is crucial for scalable and sustainable growth.

In this article, we’ll discuss why we believe that it’s good practice to factor VAT into your profitability equations from the outset, even if you’re not currently VAT-registered.

Assuming Future Profitability: A Proactive Approach

Unless you’re planning on running a boutique, lifestyle e-commerce business, it’s sensible to operate with the expectation that your business will scale. That means there will become a time when your revenues will cross the VAT threshold, meaning that VAT registration is not a question of "if" but "when."

In the UK, the VAT threshold is £85,000 per year so it might not be too long before you’re forced to register. By factoring VAT into your profitability calculations from the very start, you will be building a more robust and realistic business model for the future.

If you’re on board with this, there are several things which you need to consider.

Strategic Pricing: Matching Market RRPs

The first thing you might be tempted to do is to set your RRPs below market price, possibly to gain an edge over the competition or to get your margins right from the start. This is wrong for several reasons!

As an example, if you have a product which normally retails at $10, if the VAT rate is set at 20%, the retail price excluding VAT is $8.33 ($10 / 1.2).

So technically, you could still list your product for $10 and pocket the $1.66 that VAT registered companies collect for the government.

Reason 1 - Frontend VAT

If you’re not VAT registered, you will actually be paying VAT at the frontend. Meaning, if you are importing products from abroad, you will be paying duty + VAT on import; or your local supplier will be legally required to charge VAT if you are not registered.

Paying VAT at the frontend is much better for your cashflow than collecting it at the backend, but given that you’ve paid VAT in the first place, you should be using some of that $1.66 to offset the VAT you’ve already paid.

Reason 2 - Market dynamics

By reducing your prices you would essentially be undercutting competitors which could disrupt market dynamics, potentially triggering a price war. Ultimately, this might negatively impacting the market you’re planning on entering so it’s a very short-sighted approach.

Reason 3 - Optics

Engaging in a price war will definitely put your brand on the radar(s) of your competition and, in our experience, it’s definitely better to be as under the radar as possible whilst starting to build your brand and reputation.

Reason 4 - Devaluing your product

Setting a low price point for your products may tempt many customers, but it’s a know fact that customers devalue products when they are significantly cheaper than the leading brands. Building a strong brand with products priced reasonably is a great way to build customer loyalty and longevity for your business.

Reason 5 - You’ll struggle to increase prices

What happens when you cross the VAT threshold and you need to add the VAT back into your RRPs? Correct, you can’t. Price increase of 20% is certain to put off existing customers, especially those who have bought into your brand because of the low low process. And there’s no way in the world that you’d be able to absorb the added 20% from your margins, and this in itself is a strong enough reason to think about RRPs in this way.

Cashflow vs. Profitability

Cash flow refers to the movement of money in and out of your business and when healthy ensure the long-term success of your business.

Cash flow, however, is not the same of profitability which we measure using started terms such as gross margin, net margin, operating margin and even EBITDA.

This about cash flow as what moves in and out of your bank account: when you’ll get paid for things, and pay for things. Profitability is how the unit economics of your sales rolls up to define the overall health of your business.

In our reporting, we always separate the two.

As a non-VAT registered business, you may benefit from a short-term cashflow boost since you’re not collecting VAT on your sales. By all means, use this to provide additional working capital to reinvest in your business, but keep an eye on the true profitability of your business as it would be after you become VAT registered.

Conclusion

For e-commerce businesses, the decision to factor VAT into profitability calculations, even when not VAT-registered, is a strategic move that prepares you for future growth. Setting prices to match market RRPs while considering VAT ensures that your business remains competitive without destabilizing the market or your profit margins.

While the short-term cashflow benefits of not collecting VAT might seem appealing, they should not distract you from the bigger picture of long-term profitability. By adopting this proactive approach, you position your business for sustainable success, ready to thrive when VAT registration becomes a reality.

In our next article we’ll share our equations for calculating net revenue and net margins.

Paul Grieselhuber

Paul Grieselhuber

Founder, President

Paul has extensive background in software development and product design. Currently he runs rendr.

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