The days are gone when it was "growth at any cost," and investors happily poured money into unprofitable, growing e-commerce companies. To survive, you need to understand and control your e-commerce's profitability. In this blog post, we'll discuss the key components of e-commerce profitability and what you can do to improve it.
At a glance, profitability might seem straightforward: revenues minus costs. It would be that simple if you sold one product, used one marketing channel, had only one specific and homogeneous target audience, shipped to only one country, used one shipping provider, etc. However, that's not the case, and when you dig a little deeper, the intricacies begin to unfold in the complex topic of e-commerce profitability.
The E-commerce Contribution Margin formula
Let's start with the Contribution Margin formula, i.e., E-commerce Operational Profits, looks like this
Net Sales = Gross Sales - Returns
Contribution Margin 1 = Net Sales - Cost of Goods Sold
Contribution Margin 2 = Contribution Margin 1 - Fulfilment Costs
Contribution Margin 3 = Contribution Margin 2 - Marketing Spend
What is Net Sales in e-commerce?
Returns play a more or less significant role in the Contribution Margin for different businesses. Some e-commerce companies, like Beauty and other niches, only have a couple of % percentage points in returns that result from incomplete deliveries. And then we have all other e-commerce businesses, ranging from quite a bit of returns to many returns. This erodes your margins fast, and you know it. But you need to dig deeper into what drives your returns and follow up daily to expect to improve it.
What is Contribution Margin 1 in e-commerce?
After accounting for the returned items, we can set the Cost of Goods Sold. In general, the purchase price of the products + cost of transport and in-deliveries at the warehouse.
So, the defining part of your Contribution Margin 1 is your product's starting margin, and if you have any discounts added, that will decrease your Contribution Margin 1.
Then there's the discounts—a powerful tool to drive sales, but they can quickly diminish profitability if not managed correctly.
What is Contribution Margin 2 in e-commerce?
The dramatic variations in logistic costs between products and countries, including picking, packaging, shipping, and customs, are part of the complexity of creating your Contribution Margin 2. If you have that data, that's almost always a place to find low-hanging fruit when optimizing your e-commerce business' profitability.
This is your Contribution Margin 2, and its effect is both the actual costs at this stage and the Contribution Margin 1 that's left after COGS to carry the fulfillment costs. Look at this straightforward example of 3 different orders.
Order 1
Three smaller products in the basket with low initial Gross Sales but no discount, low returns, and good starting margin. Gross Sales of 300, Contribution Margin 1 200, and fulfillment cost of 50 result in 150 in Contribution Margin 2.
Order 2
One big product is in the basket with high initial gross sales, high discounts, low returns, and an okay starting margin. Gross Sales of 500, Contribution Margin 1 of 200, and fulfillment cost of 150 results in 50 in Contribution Margin 2
Order 3
An order with the same products as in order number 1 and order number 2, but now it is shipped to another country with higher return rates and shipping costs: 300 in Contribution Margin 1 (due to higher return rate), and in this case, we get some economies of scale for the fulfillment costs, BUT the shipping cost is higher so the fulfillment cost is now 250, leaving us with a Contribution Margin 2 of 50
In this case, we can see that Order 1, with Gross Sales of. 300 was way better than Order 3, with 800 in Gross Sales.
That's the complexity of e-commerce in a nutshell when scaling globally.
What is Contribution Margin 3 in e-commerce?
Marketing costs are more broadly understood and analyzed than the fulfillment side of e-commerce. But unfortunately, it is analyzed concerning Gross Sales. Return on Ad Spend (ROAS) or Cost of Sales (COS).
To get our Contribution Margin 3, we take our Contribution Margin 2 and add our marketing spend. When done right, and when the whole commercial team (marketing and buying) is measured on Contribution Margin 3 instead of vanity metrics such as ROAS and GM1, this tremendously affects the way of working.
To continue on our example from above, given that why have the same Cost-Per-Order 50, a marketer measured on ROAS would have been incentivized to prioritize sales oppositely than what you want if you want to maximize profitable growth. The highest ROAS is on Order number 3 (800/50=16), and the lowest is on Order number 1 (300/50=6).
When measured on Contribution Margin 3, a marketer quickly sees that Order 2 and 3 yield 0 in Contribution Margin 3, and Order 1 yields 100. The marketer can then work proactively together with buying, and vice versa, and ask the vital questions for maximizing profitable growth
- Which products should we market in which countries?
- What is the ideal price point for our products in different countries?
- Given the general shipping costs, what is our minimum Contribution Margin 1 per market?
- Which countries yield the best contribution margin 3, and therefore should get the most marketing spend? (until worse countries' profitability issues are solved)
How to improve Contribution Margin 3 in e-commerce?
Given that all these costs aren't uniform. They can differ vastly between countries, products, and individual customers. This presents a unique challenge for an e-commerce business operating globally. How do you track and optimize these varying costs on a granular level when they fluctuate daily? The profitability lies below the averages, and you cannot expect to succeed if you don't delve deeper. You need to have the answers at hand, a click away, updated in real-time, to monitor the effect of all attempts to improve your Contribution Margin.
All this and more get answered in a few clicks in Dema's e-commerce analytics platform, and there you can do the deep analysis and save a report showing, for example, week-over-week changes.