Unit Economics: The Best Way to Improve Your E-Commerce Gross Profit

Posted on February 24, 2017

E-commerce stores are driven by unit economics while the global financial statements are driven by thousands of smaller transactions. For most stores, this means making the same (or similar) transactions thousands or even millions of times.

If you can optimize one transaction,  your efforts will be multiplied through every future transaction.

While improving items such as conversion rate and the number of lifetime purchases, and virality can have an even larger effect, as you will see a focus on improving variable that contributes to gross profit variables is worth the effort.

Let’s begin by defining a few terms I’ll use while discussing unit economics throughout the article:

AOV = Average Order Value — the average dollar amount of each store transaction.

COGS = Cost of Goods Sold — the wholesale cost of the goods in an average order.

Shipping Costs — the average cost of postage for an order

Fulfillment Costs — a bucket of additional costs incurred when fulfilling an order.  This can include credit card transaction fees, packing materials, labor, etc.

The first step in improving gross profit per order is to determine the gross margin dollars contributed by an average transaction.  To do this, simply take your Average Order Value, subtract the cost of the goods sold in that transaction, subtract shipping costs, and finally subtract fulfillment costs.  It looks like this:

AOV – COGS – Shipping – Fulfilment = Gross Margin Dollars

So, for a store that has a $100 average order, $50 cost of goods (50%) , $10 in shipping (10%), and $5 (5%) in fulfilment and transaction costs (packing materials, credit card fees, etc) their equation looks like this:

$100 – $50 – $10 – $5 = $35 in gross profit per transaction

If you practiced aggressive upselling and cross selling, perhaps you could add 20% to your average order value.  If you did that, your new unit economics would look like this:

$120 – $60 – $12 – $6 = $42 (a 20% improvement in gross profit per transaction)

If, instead, you focused on negotiating a 20% better deal with your wholesale supplier, your original equation would look like this:

$100 – $40 – $10 – $5 = $45 (a 28% improvement in gross profit)

If you focused on negotiating a killer deal with FedEx or UPS and lowered your shipping cost by 20%, your original equation would look like this:

$100 – $50 – $8 – $5 = $37 (a 6% improvement in gross profit)

Finally if you focused on improving your fulfilment costs by 20%, your unit economics would look like this:

$100 – $50 – $10 – $4 = $36 (a 3% improvement in gross profit)

While some variables will be easier to improve than others, in my experience analyzing hundreds of under-optimized stores, it’s relatively feasible to improve EACH of these variable by 10-20%.

Improving multiple variables in tandem is where the real magic happens.  Take a look a the compounding effect of improving each variable in the original equation by 20%:

$120 – $48 – $8 – $4 = $60 (a 71% improvement in gross profit!)

While this is not an exhaustive list, here are a few suggestions on how to improve each of these gross margin variables:

Average Order Value – cross selling related products, upselling to higher dollar value items, setting or raising a free shipping threshold (free shipping over $100), discounts off a minimum purchase ($25 off $250), volume discounts, package deals, etc.

Cost of Good Sold – building your own private label alternative, simply asking for and negotiating a lower price with vendors.

Shipping Costs – negotiate a better rate with multiple shipping providers, using shipping rate comparison software to choose the lowest rate among multiple shipping companies, enabling slower alternatives such as the USPS, Surepost and Smart Post.

Fulfillment Costs – negotiate a better credit card rate — rack rates with vendors such as Shopify can approach 5% whearas high volume etailers pay just under 2% in transaction fees, optimize your use of packing materials, reduce labor costs by streamlining bottlenecks in your fulfilment operation.