Unit economics is one of the most powerful concepts to get right for any business. It helps guide business strategy because products, sales, supply chain and marketing are all in line.
A “unit” in ecommerce unit economics can be defined in terms of per order or per product sold, after deducting all variable costs. Getting your numbers right is the path to profitability and without it, your business could just be feeling around in the dark.
Top-line revenue gains might have worked in the past. They might still work if you have deep pockets or a venture-capital-backed war chest.
For most of us, however, bankable profits is our priority.
Understanding Ecommerce Unit Economics
Only when we understand how the smaller moving parts of each department influence our financial model, can we make adjustments to optimise.
Regardless of what you sell, ecommerce business models always come down to the same equation.
Simply put, it means:
How much does cost take to get one click (T), acquire them as a new customer (CR), retain that customer (LTV), and deliver that one product (VC)?
Breaking Down Unit Economics
Unit economics and pricing
- What impact do discounts have on sales volume, order value and the resulting profit
- How does free shipping or free products for customer orders over a certain value affect profit
Unit economics and supply chain/ logistics
- A change in warehouse, courier or manufacturer can affect landed COGS
- Logistics issues like wrong orders, damaged packaging, late delivery etc can lead to higher return rates and higher churn
Unit economics and marketing
- Expanding into new markets could result in higher sales taxes, import duties and delivery fees
- Different channels have varying effectiveness in driving traffic to your site, which affects CAC
- The level of understanding of the customer journey could result in fewer conversions
- One-click upsells, pop-ups, social proof, urgency tactics etc could increase AOV
- Campaigns and giveaways could also affect customer lifetime value
Variable Costs vs Fixed Costs
With fulfilment, there are always going to be costs involved.
But not all costs are the same.
For the most part, there are two types of costs associated with sustaining an ecommerce business; variable costs and fixed costs.
Variable costs are directly affected to making a sale. More specifically, the costs change as volume changes. Think raw materials, production supplies, delivery costs, packaging supplies, commissions, credit card and platform fees etc.
Fixed costs remain the same regardless of production output. They include rental, salaries, interest expenses, utilities, software subscription costs etc.
Cost of Delivery
The bulk of variable costs is the cost of delivery (COD). It’s every product-related expense from creation in the factory until it reaches the customer’s hands.
- Cost of goods sold (COGS)
- Shipping and receiving fees
- Transaction fee
- Pick-and-pack fees
1. Cost of goods sold (COGS)
Cost of goods sold (COGS) refers to the production cost of one unit. This can be the price you’ve arranged with a manufacturer – the costs of materials and labour.
2. Shipping and receiving fees
For the layman, shipping refers to delivery to the customer. But here, we mean loading, unloading and shipping to you and/or your third-party logistics (3PL) provider. Storage and warehousing per unit can be included here.
3. Transaction fees
Transaction fees are also known as payment processing fees.
Alongside major credit cards, the most popular payment fees are Stripe, Paypal, Shopify Pay, and buy-now-pay-later gateways like Hoolah or Klarna.
4. Pick-and-pack fees
After an order has been placed, the item has to be “picked” off the shelf and “packed” into a box to be shipped.
After COGS, shipping to the customer is the next biggest cost in online retail. Some merchants like to pass this cost on to the customer and include this within the retail price of their products. If this is the case for your business, don’t include it in your variable costs.
On the other hand, if your business bears the cost, then cost will vary based on carrier, product dimension/weight and shipping speed.
6. Returns (aka reverse logistics)
Returns are to be expected in the sales cycle. Return costs may include a return shipping fee, refund processing, repacking the item, and discounting the item if its expiration date is drawing near by the time it’s back on the shelf even.
Calculating Ecommerce Unit Economics
Below are the key data points used to calculate unit economics. Generally, the numbers we used are in aggregate, divided by the number of orders shipped in the month.
(a) Basket Order Value
The average sales value per order (before any applied discounts)
(b) Less discounts applied
Average discount per order
Average Order Value
(c) Less refunds
The average refund amount issued on every fulfilled order
(d) Less landed cost of goods sold
The cost of materials, manufacturing and assembly, any shipping and receiving fees until it has reached your warehouse
(e) Plus returned stock
The average cost of stock that is in good condition and resellable, after repackaging, discounts and other related costs per order
(f) Less replacements
The average landed cost of goods to replace an order for a dissatisfied customer per order
(g) Less stock write-offs
The average landed cost of goods that cannot be sold due to damage, loss or theft
= Contribution Margin 1 (CM1) (aka product margin)
(h) Plus shipping revenue
Average shipping charged to customers per order
(i) Less pick and pack fees
Depends on what your warehouse charges per order
(j) Less transport fees
Average transport charges per order by your courier for delivery to customer
(k) Less return charges
Return transport fees and processing fees per order
(l) Less transaction fees
Commission charged by your website’s payment gateways and platform fees like Shopify, Klaviyo, other apps that take a percentage per order
= Contribution Margin 2 (CM2) (aka gross profit)
(m) Less variable marketing spend
Marketing spend on online/offline advertising, affiliate commissions, agency fees etc
= Contribution Margin 3 (CM3) (aka nett profit per order before sales and taxes)
(n) Less sales taxes
Sales taxes and import duties charged by the country you’re selling in
= NPAT (Nett profit after tax)
Customer Acquisition Costs and Profits
Customer acquisition cost equals your total marketing expenses and other costs involved in acquiring customers divided by the number of new customers generated.
It’s your total advertising budget, discounts, creative costs, agency fees, payroll for internal employees.
So how much should you spend to acquire a new customer?
Answer: Gross margin – nett profit target
High enough, your gross profit can fuel CAC. For example, if your product retails at $100 and your COD adds up to $48, you’re left with $52 per new customer to power your acquisition strategy and still break even.
Here’s a general guideline that will keep you afloat:
- Retail price > 4.5x landed COGS
- Product margin (minus landed COGS) > 75%
- Gross margin > 50%
- Nett profit > 20% retail price
Using Unit Economics to Decide on Offers
Now that you know your unit economics, use the same numbers to calculate what offers make sense for your business.
Test different combinations – free products with threshold, discounts, free shipping, it’s up to you.
Compare how each offer compares to one another and make a more informed decision based on your numbers.
At last, you can make smart choices that put your business’ bottom lines first. It all starts with your ecommerce unit economics.
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