All businesses start with a specific goal in mind. For most, it’s profit.
Even at not-for-profit organizations – or when the main driver of a business is a personal goal, like being able to work in a more flexible way or spending more time with family – income is almost always required for sustainability.
Entrepreneurship can deliver on the various freedoms it promises, but success requires an active understanding of a business’s finances – which starts with knowing what to measure.
As management consultant Peter Drucker says, “What gets measured gets managed.” – so here are four key metrics of eCommerce profitability.
1. Gross profit margin
Gross profit margin is “a financial metric used to assess a company’s financial health and business model by revealing the proportion of money left over from revenues after accounting for the cost of goods sold (COGS).”
Gross profit margin is critical because it immediately gives you an overview of how your current revenue is serving the rest of your business, and whether it is doing so at a profit or a loss. This has a far-reaching impact on your strategic and tactical options for how to run your business.
Consider: you only have a gross profit margin of 10% and monthly revenue of $100,000. That essentially means that you are only earning $10,000 per month from selling your goods, and that’s before your you have paid any of your other expenses (or paid yourself a salary).
Compare that to a scenario where you have a 50% gross profit margins — you only need to sell $20,000 worth of product to earn the same gross profit. This business model does not rely on the same high volume of sales to generate profit. You might find that it also requires less of your time and fewer other expenses to run a $20,000 business than a $100,000 business.
What this also showcases is how an obsession with revenue — instead of profitability — could be harming your business. I don’t deny that it feels great to tell friends that you have a 6-, 7-, or 8-figure business based on revenue. But perhaps you are working 80-hour weeks to achieve that, and it’s not even that profitable or paying you a market-value salary.
An obsession with revenue — instead of profitability — could be harming your business.
Here are a few tips to improve your understanding and overview of your gross profit margin:
- Invest in your inventory tracking. The cost of your inventory is the primary driver of your COGS, which is what you use to calculate your gross profit margin. If you don’t have reliable information about what your inventory costs and how that relates to your sales, you are starting with an unstable basis.
- Be as granular as possible. Find all the variable costs that are directly associated with making a sale and include them in your calculation. If possible, include all of your freight, import, and manufacturing costs, as well as expenses like packaging and shipping. The more accurately you can calculate your COGS, the better the insights that you can garner.
2. Customer Acquisition Cost (CAC)
Your Customer Acquisition Cost is the average dollar amount you spend to acquire a new customer (i.e., attracting them and persuading them to make a purchase from you).
This is the easiest way to calculate your CAC:
Like calculating your gross profit margin, calculating your CAC means scrutinize your expenses and finding all of those that relate to marketing. Here are a few of the more common costs most eCommerce businesses incur:
- Paid advertising on Facebook Ads or Google Adwords, along with any offline ad spend.
- Software, like your email marketing solution and your popup / lead capturing tools. If it is somehow involved in identifying and capturing a new customer, include the cost here.
- Geam members that are specifically involved in marketing — you can allocate either their full salary or a portion based on how much of their time they spend on marketing when calculating your CAC.
Say your Total Marketing Expenditure is $5000 for this month and you acquired 500 new customers with that spend. That means that your CAC is $10.
Now let’s extend this by including some of your other metrics. Say your Average Order Value (AOV) is $100 and your gross profit margin is 20%, which means that your average new customer is worth $20 to you. In this scenario — based on a CAC of $10 — you are acquiring new customers in a profitable way and you have a solid foundation from which to encourage them to make repeat purchases over time (which will increase their lifetime value and profitability to you).
Oftentimes, businesses find that their CAC is out of control and exceeding their gross profit margins. It’s possible to use a loss-leader strategy in the short-term and for some products, but selling your products at a loss over an extended period of time may put your business at risk.
This is what happened to Bento, an on-demand food startup, who saw revenue growing nicely. But the more their revenues grew, the more money they were losing. Instead of growing stronger, their business veered towards a cliff at break-neck speed because they didn’t have either their gross profit margins or CAC dialed in.
Once you have a good idea of what your CAC looks like on average, there are two ways to extend your monitoring and insights further:
- Calculate your CAC per marketing/acquisition channel. This comparison reveals where you are find your better-qualified customers, which can help you prioritize where you spend your marketing money. To do this, split up the total expenditure and the customers you acquire can calculate your CAC for each marketing channel. Say you do that for Facebook Ads and Google Adwords and determine that their CACs are $5 and $20, respectively. It might make sense to stop the more expensive Google Adwords and invest more heavily in Facebook ad campaigns.
- Do something similar for specific products or product collections. This is especially interesting if your products have a wide range of gross profit margins, because you may decide that you can spend more to acquire customers of higher-value products or products with a very high margin. This calculation also helps when implementing a loss-leader strategy, where you actually make a loss on selling some products as a way to lure the customer in and then up-sell them on products with better margins.
3. Your discounting strategy
Gross profit margin and CAC are the building blocks for creating a good discounting strategy. Too often, I see eCommerce businesses with an aggressive and significant discounting strategy — but with zero visibility into how that relates to their gross profit and CAC.
Consider this scenario:
- You have an Average Order Value (AOV) of $100.
- A gross profit margin of 30% leaves you $30 gross profit on an average order.
- Your CAC is about $15, which means you are earning $15 per $100 order (or about 15%).
If a discount exceeds 15%, this business likely making a loss on that sale.
Making a loss on some sales might not be a problem; when you do it as a loss-leader strategy, it can be very beneficial. But you can only know that you are in a safe space if you understand what your discount strategy looks like relative to your gross profit margin and CAC.
To help you better evaluate this, there are a couple of things that you can do:
- Look at your maximum discount amount or percentage and determine how that relates to your gross profit margin and CAC. In the example above, the threshold for the maximum discount should be about 15%. Any campaign or promotion that requires a discount greater than 15% here should be investigated and re-evaluated, because they are the biggest risks (in terms of unsustainable losses).
- Understand your discounts in terms of percentages. Depending on the exact campaign you are running, a fixed discount (i.e., $20 off) might makes more sense than a percentage discount. When using a fixed amount discount, you should still determine what percentage of your AOV that would be. So if your AOV is $100, then $20 OFF is an effec,tive discount of 20%. In the example above above, that effectively exceeds the 15% threshold which should prompt greater scrutiny of the campaign you plan to run.
You are in a safe space if you understand what your discount strategy looks like relative to your gross profit margin and CAC.
4. Free cash flow
Many businesses die because they run out of cash — even businesses that show an accounting profit.
All of the metrics above impact your financial profitability: If you only monitor these and improve them over time, you should see your profitability grow nicely. But for a holistic and complete analysis, you should still weigh growth in profitability against the availability of cash in your business.
First, let’s look at a definition for free cash flow first:
“Free cash flow is the cash a company produces through its operations, less the cost of expenditures on assets. In other words, free cash flow or FCF is the cash left over after a company pays for its operating expenses and capital expenditures.”
There’s a common scenario where free cash flow hampers a business: Most payment processors implement a payment schedule for payments that you process. So even if you have $1000 in sales and payments processed today, your payment processor may only transfer those funds to you in 7 or 14 days’ time. Your payment processor is a debtor to you in this regard.
When you order new stock from your supplier, they expect payment before they deliver that stock. To make that happen, you need cash reserves. If you are unable to pay for that stock, you may lose out on upcoming sales because you have no available inventory.
This is why it is important to understand how much cash flows in and out of your business on a monthly basis; you can then plan accordingly and keep an appropriate level of cash in reserve for unexpected expenses. Doing so will help you maintain both safe margins for emergency scenarios, but also ensure that you always have funds available to reinvest in your growth.
Your first step to financial freedom
It’s hard to build a successful business without really understanding these metrics. The starting should always be putting better tracking and monitoring in place. If you don’t have any insight into these metrics and you just started tracking them, the absolute numbers matter less. What matters more is that you have started the process, which will help you make improvements over time.
Beyond getting better reporting in place, I hope that I have planted the seed that it is possible to build your business that will allow you greater freedom. Counterintuitively, taking a step like revising your discount strategy -– and decreasing your revenue in the process –- might be the way you end up earning more profit (and working less!).
These four key metrics will give you more options into how you leverage and tweak things in your business to ultimately serve its purpose: achieve the goals you have set for yourself.