Getting to grips with ecommerce: Part 1
Welcome to part 1 of a series of ecommerce opinion pieces, written to help increase your revenue and lower your cost per acquisition.
Part 1: Do not spend a penny on ads until you have checked the following…
Things that frustrate me:
- People using their phones while I’m trying to talk to them.
- The ice-cream machine not working in McDonalds.
- Co-workers hovering over my desk while I’m trying to write this article.
- Clients wasting their money on paid ads.
It is the last point that I want to talk to you about today. You see, ecommerce is so much more than just running paid ads.
Yes, it is important (very important in fact: no traffic equals no conversions). But there are many other factors, both within an agency’s control and out of an agency’s control, that can affect the outcome of your paid activity and your ecommerce business in general.
I want to run you through some of the things that I personally check before I start running any ads for clients.
Profit Margin, ROAS, AOV and LTV
The very first thing I do, is run the numbers to see whether we can even be profitable running paid ads.
I’m looking at two key things here:
- How much is it costing us to acquire a new customer?
- How much profit are we getting out of that customer during their lifetime?
Simply put: if it is costing me more to acquire a new customer than the profit they will generate, then no matter how much traffic we drive through paid media, the business will struggle to scale and ultimately grind to a halt.
To work this out, there are some metrics we’d need to know at the start.
In a nutshell, your profit margin is the difference between your revenue and cost of goods sold (COGS) divided by revenue and is typically shown as a percentage.
The formula looks like this:
(Total revenue – cost of goods sold) / total revenue
The higher your profit margin, the more money you’ll keep on each sale. So higher the better.
What is a good profit margin?
This is usually the next question I get asked and I’m afraid it’s not something I can answer with any real conviction. It completely depends on the nature of your business, your pricing strategy, the level of competition in the marketplace etc.
What I will tell you is this: operating with low profit margins means that your advertising must work that much harder and, in some cases, we may never be able to reach the minimum ROAS (return on advertising spend) required to be profitable.
To calculate this, you simply divide your revenue by the amount of money you have spent on ads. Depending on who you speak with, this can be expressed as a percentage, a number, or a ratio. Personally, I report on it as a number.
So, for example, say I’ve spent £1,000 on an advertising campaign that has generated £5,000 in revenue (we won’t worry about attribution for now, we’ll save that for another day). Then the calculation looks like this:
£5,000/£1,000 = 5
So, for every £1 we have spent on advertising, we have generated £5 back.
What is a good ROAS?
I knew that you were going to ask that. And again, I don’t have a solid answer because it depends on your profit margin, your average order value, and your customer lifetime value.
You would be mistaken though to think that you want to always achieve the highest ROAS possible. This isn’t always the case. You want to be aiming to achieve the minimum ROAS that allows you to be profitable.
Let me explain…
If you lower your ROAS (and are still able to be profitable) then this means you can spend more on advertising. Not only this, but you are then able to acquire new customers at a higher cost per acquisition (CPA), which means you are then able to outbid your competitors and scale your ecommerce business more aggressively.
It is a question of profitability vs growth, or in other words, efficiency vs effectiveness. We want to make sure that we strike the right balance between the two.
This means if we only focus on achieving the highest possible ROAS, then although we will reach a level of great efficiency and profitability, we will be missing out on potential growth, by acquiring new customers at a slightly lower (but still profitable) ROAS.
In this case, bigger is not always better.
This is your average order value, and you calculate this by dividing your total revenue by the number of orders.
So, if our ecommerce revenue for the month was £85,000 from 700 transactions, then our AOV would be:
£85k/700 = £121.42
Your AOV will affect your GROSS Profit Margin.
A low profit margin, combined with a low AOV makes things almost impossible. You would need to be achieving a minimum ROAS of x30, x40, or x50, to be profitable working under such strict conditions, which is extremely difficult to achieve consistently over the long term.
There are certain strategies and tactics you can deploy to increase your AOV, and I’ll touch on those in later posts.
The final piece of the puzzle is your Lifetime Value (LTV), which is the average revenue that a customer will generate throughout their lifespan as a customer.
There are many ways to calculate LTV. The one we use at Space & Time, looks like this:
CLV = Customer Value x Average Customer Lifespan
But there are many other ways to slice and dice this. Plus, if you are using an ecommerce CMS like Shopify then there are dozens of apps you can use that will calculate this automatically for you and save you the headache.
Like with AOV, your LTV can have a big impact on you Gross Profit Margin and can be the difference between being profitable or not.
In fact, I used to work for a client that was able to acquire new customers at a loss, because their LTV was so high. We knew that we would be able to recoup our costs over a 12-month period (although this was based on a subscription model).
Again, there are many ways to increase the LTV of a customer and I will be covering this off later.
Bottom line, make sure you don’t succumb to the “shiny new object syndrome”, and get swept up with the euphoria of all the different media channels and types of ads you could be running before running the numbers, because this will come back to haunt you.
Regardless of whether you have run a great campaign which (on the surface) has generated a positive ROAS, if you don’t hit your minimum ROAS you’d be destined to fail from the very start.
Before we onboard any new ecommerce client, we take them though our profit margin calculator to see whether we can realistically hit the numbers needed for them to be profitable.
Please get in touch if you would like us to run our margin calculator with you.
So there you have it, my summary around profit margins, what it all means and how they are integral to a successful and sustainable ecommerce strategy. Keep your eyes peeled for part two where I will discuss reviewing conversion rates, the offer and product, creative and copy and much more.
If you need help growing your ecommerce store, please get in touch.