You see increased inflation, a meteoric rise in Acquisition costs, and a decrease in demand after the dust settled on COVID’s reality. Understandably, you’re worried: how will you keep the business afloat in such challenging times? The answer is in this eCommerce Profit Margin essential guide.
Read on and discover what it is, how to calculate it, and how to increase it sustainably through the wonders of Customer Lifetime Value.
What Is the Profit Margin?
Calculated as a percentage, Profit Margin represents the difference between the total cost to run your business (also known as expenses) and the total revenue the company brings in.
We use the term Profit Margin to describe an organization’s profitability – the higher the percentage, the more profit your business makes.
This is the simplest way to look at the profitability of your organization. However, when we talk about the profit margin for eCommerce, there are four types (or levels) of profit margins:
- Gross profit margins – the difference between the total revenue and the costs of goods sold (COGS). In this case, the COGS should only include costs directly linked to creating your product.
- Operating profit margins – this represents the money that stays with you after subtracting administrative or operating expenses (operational costs) from the average gross margin. To calculate your operating profit, you need to include fees like rent, utilities, and administrative costs in your COGS formula.
- Net profit margins – this margin is the upper level and, arguably, the most common type of profit margin. When calculating the net profit margin, you must include all business expenses (COGS, taxes, operational expenses).
Why Is the Profit Margin Important?
According to Eric Schmit, Google’s Executive Chairman, “Profit solves all problems.”
However, just seeing a positive sign in your revenue isn’t always enough information about your business’s profitability to keep the organization afloat.
The online business game, or maybe even the whole idea of eCommerce, has been going through a continuous change in recent years.
And that what moves the needle, in the long run, is the long-term strategies and the procedures you’re putting in place.
Your profit margins will reveal many insights and valuable information about your business.
From a general direction like “how is the business doing?” to specific details like “where and why are we struggling?” your eCommerce margins will answer these questions and many more.
There are many questions answered by your eCommerce profit margins.
Are we struggling with anything in specific?
After you apply the profit margin formula on all levels, you’ll get a quick understanding of where your business is flourishing and where it may be struggling.
For example, product A brings you a 45% profit margin. At the same time, product B brings you only a 21% profit margin.
Seeing this, you might want to:
- Invest more in promoting & selling product A
- Identify why product B is drowning your profits.
Are operating expenses higher for product B? Is shipping more expensive? Is the demand lower?
The answers to these questions will highlight opportunities for cost management or even process optimization.
Can we afford to lower our prices?
In this day and age, pricing is one of the critical driving forces affecting store owners’ conversion rates.
Offline and online shoppers are interested in a good deal, so your price points are crucial here.
However, setting your prices can become tricky. Depending on how high the Costs of Sold Goods bring you, your prices might need to be too high – resulting in fewer sales. Fewer sales obviously mean fewer customers and lower profits.
On the other hand, setting your prices too low could also prove detrimental to your store and lead you to a place where you’ll be losing money.
So your goal here is finding the right balance between making a profit and staying competitive.
Understanding your margins can help you decide on a markup, which ultimately helps you set more accurate pricing.
Are we sustainable as a business?
Your margins – operating margins and gross margins specifically – can reveal a lot about an eCommerce business.
For example, you can determine whether your COGS is too high for your revenue needs or if your operating expenses are consuming your profits.
It also shows you if your processes are successful or not. Profit margins help you prepare for possible cash flow challenges and get ready for growth – depending on where you stand.
With profit margins, you can also look at similar businesses and determine whether you’re on track, meeting your industry targets, or struggling to stay profitable.
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How Do I Calculate the Profit Margin?
While you can use a profit margin calculator to determine your profit margins, you should take the formula seriously. If you want to thrive in the eCommerce game, you have to understand the math behind eCommerce.
Let’s talk about formulas and calculations to determine the profit margin for eCommerce.
Gross Profit Margins
To calculate the Gross Profit Margin, you need to subtract the costs directly related to creating your product (materials, labor – known as your COGS) from the sales revenue.
Suppose you calculate the Gross Profit Margin for each product individually. In that case, it’s going to help you analyze & refine your product suite.
At the same time, you can also calculate the aggregated Gross Profit Margin – which reveals your overall profitability picture.
The formula for calculating the Gross Margin percentage:
Net Sales – COGS, divided by the Net Sales.
Operating Profit Margin
To get your Operating Profit Margin, you must subtract general, administrative, or operating expenses from the gross profit. This is the profit you get before interest and taxes.
While this isn’t a number you’ll be overly concerned about, it’s the number that bankers or evaluators will look at before considering a potential buyout.
The formula for calculating Operating Profit Margin:
Divide your Operating Revenue by the revenue, then multiply by 100.
Net Profit Margin
To calculate the Net Profit Margin of your eCommerce store, you need to divide the net profits by the net sales.
You can also divide the net income by the revenue brought in over a specific period.
You can determine your net profit by subtracting all expenses (including materials, labor, operations, rentals, interest payments, and taxes) from your total revenue.
Of course, you don’t have to calculate it and monitor yourself; eCommerce platforms exist for this.
What’s a Good Profit Margin in eCommerce?
Generally speaking, you should take a variety of approaches to set a revenue or profitability goal.
Look at the general consensus for the profit margin for your eCommerce:
- 5% is a low-profit margin,
- 10% is a healthy one,
- and 20% is an excellent profit margin.
You can check Omniconvert’s real-time eCommerce benchmark for more information and statistics from your industry.
How Do I Improve My eCommerce Profit Margin?
Now, the question on everyone’s minds is: “ok, how do I improve my Profit Margin?”
There are some ideas you can consider when trying to improve your profit margin, such as:
Going For a Price Increase.
This is the most common approach, and we see it everywhere, with the rise in gas & electricity costs. From sugar to clothes, everything is more expensive.
Raising your prices would bring in more revenue for each purchase. However, a cost spike might alienate your customers and cause customer churn.
Reducing Your Expenses.
As you saw in the formula, your expenses are precisely half of the story regarding profit margins.
If you see expenses eating into your profits, you can optimize and reduce costs as much as possible.
You can also automate specific tasks your organization carries out regularly or find tools & software to take the manual legwork out and free up employees’ time.
Eliminate Processes Holding You Back.
Look at how you spend your budget, produce your products, and other factors impacting revenue generation or costs.
Identify where you could do better and work to correct those factors. You can increase your profit margins; it’s doable. Unfortunately, you can’t go in blind without auditing your processes.
Now, these were the obvious routes that organizations take to improve the profit margin in eCommerce.
However, now that retailers are waking up to the reality that acquisition isn’t enough to keep a business profitable.
With this epiphany in mind, trailblazing eCommerce brands are turning towards the dark horse of eCommerce: the Customer Lifetime Value.
A better, more innovative, and sustainable way to increase your company’s profit margins is to focus on getting more value from your current customers.
You can predict and improve your company’s profitability by looking at the relationship between Customer Lifetime Value and Customer Acquisition Cost.
If the ratio is around 3:1, you’re bringing three times more Lifetime Value than the Acquisition Cost. Which should reassure you that you’re on the right path and your business is healthy.
However, if it exceeds 3:1, you’re keeping your money in the bank, so you won’t see an increase in your company’s profit anytime soon. You’re missing your opportunity for expansion.
If the ratio is 2:1, your business skates on thin ice, and unless you make a change, you’ll soon start bleeding your budget all over the acquisition step.
If the ratio lowers under 2, say 1.5, or even 1.8, you don’t earn any profit.
In conclusion, your best approach to increasing your profits is applying the Customer Value methodology to earn more from your existing customers.
Customer Acquisition is significantly more expensive than retention. On the other hand, an increase as small as 5% in retention can spur a 95% increase in profits.
Therefore, look towards your existing customer base to increase your profits without increasing operating expenses.
Look at the first ordered product & all purchases that follow, then identify products that brought customers with the highest CLV.
Combine this information to create smarter acquisition campaigns, pushing the products that brought you the most profits in the past.
Of course, it requires in-depth analysis, but it’s cheaper than mass marketing done without rhyme or reason.
You need to track what matters to keep a customer and improve the customer experience. That shows you how you keep that customer.
Suppose you use a segmentation method such as RFM. In that case, you find the customers with the highest Customer Lifetime Value who are coming back and buying again.
If customers have the desired behavior and know what they are buying, you will not spray and pray anymore.
For some business models, this is the crucial ingredient. For others, it’s a fantastic growth path and a strategic advantage.
> Get started on Customer Value Optimization with our CVO Academy! World-class experts teach you advanced CVO tactics to set your eCommerce store for success.
Check out the courses and master all eCommerce tactics from acquisition to retention!
How to Preserve Your Profit Margins as You Grow
It only takes a glance at the last three years we lived through to realize that growth cycles only last for a while.
The question isn’t if we will face an economic change (again). It’s when will it happen?
So, to keep profit margins constant as your business grows and you see increased sales, check out the following action items:
Create a Strategy
Successful companies are those that plan ahead to spot opportunities and direct their resources to seize said opportunities.
At the same time, these companies are aware of potential risks and learn from the past. You can look at how previous economic shifts affected your organization, industry, and customer base.
You should ask hard questions to identify strategic initiatives to increase and preserve profits.
Combining new opportunities with the past’s wisdom and the truth revealed by hard questions, you can create a plan to keep a steady stream of profits no matter how much you’re growing.
Take Care of Your Customer Base.
As a business expands and gets more customers, it’s only natural the customer care department might get overwhelmed, and some customer issues might fall through the cracks.
Use RFM segmentation and customer care surveys to quickly identify friction points and prioritize problem-solving. Create memorable customer experiences to increase CLV and loyalty.
Make Data-Driven Decisions
Use your customer data to make better decisions and step away from basing your strategy on gut feelings or trial & error.
Your data is a strategic advantage, revealing what’s uniquely yours. It’s time you rolled up your sleeves and started leveraging it.
Be Flexible About Your Office-Working Policies.
Yes, we are going there.
In the era of remote working, rigidity about getting your employees in an offline environment can do more harm than good.
As you grow and expand, you will hire more employees and have to rent bigger office spaces. Even if we look at it from a strictly cost vs. profit lens, you can agree that real estate costs you more than it produces.
If anything happens and people start working fully remotely (again), you might find yourself with too much office space on your hands and too much time left on your lease. This translates into increased expenses that don’t return your investment.
Wrap-Up
Yes, your Profit Margins may be tricky – but they aren’t impossible to tackle.
However, you need constant vigilance when balancing your expenses vs. your earnings, as well as a customer-centric mentality.
Don’t get lost in chasing the cash flow and forget about the customer base.
When it all comes down to it, your customers are those who control your revenue – no matter what you say or how great your products are.
If you’re interested in doing smarter eCommerce, keep an eye on this space: you’ll find courses, webinars, and more articles that will help you stay afloat and keep the momentum going.
FAQs
What Is a Good Profit Margin for a Product?
A good profit margin depends on the demand, the operational expenses, and on your prices. High end and luxury items usually turn higher profits, since prices are also higher. At the same time, common products or restock-able products are bought more frequently, so they also return high profits.
How Are Ecommerce Margins Calculated?
Gross profit margin is the difference between the total revenue and the costs of goods sold (COGS). Operating profit margin represents the difference between the gross margin and the administrative or operating expenses. Net profit margin is calculated by dividing the net profits by the net sales.
What’s a Good Profit Margin for a Small Business?
While there’s no straight offer, industry benchmarks tell us that the average profit margin for a small business ranges between 7% to 10%. Anything higher than is excellent. If you encounter lower margins, you need to change your strategies and try and earn more from your existing strategies.
What Challenges Can Impact eCommerce Profit Margins?
Ecommerce businesses may face challenges that affect profit margins, such as intense competition, price wars, rising costs of marketing, fulfillment, and shipping, fluctuations in supply chain or raw material costs, and economic factors impacting consumer spending habits. Staying vigilant and adapting strategies to address these challenges is crucial for maintaining healthy profit margins.
