Unit Economics for eCommerce Businesses

Unit Economics for eCommerce Businesses

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Unit economics is one of the most important metrics to get right for any business. It is a powerful tool that will help direct the business strategy and focus for correct products, sales, supply chain and marketing.
Unit economics is the profit or loss per order (after deducting all variable costs) that contributes to the overall business performance. Unit economics determines a business’ route to profitability and without it can mean the business is flying blind. 
Without a firm grasp of the Unit Economics for any business, it is impossible to determine what actions taken in strategy and marketing will have upon the profits and losses of a business.

Discounting versus Value-Adding (always a safer approach)


At the end of this article is a theoretical case study scenario outlining the concept and logic.

A savvy customer is looking for a product or service that feels more like an investment than a purchase. If buying a programmable thermostat will pay for itself in 2 years, the price becomes a little more secondary because it’s an investment. Don’t focus on what the customer pays out — focus on the rewards.

Sometimes strategy and spin doesn’t work if you’re in an ultra competitive industry known for offering discounts. If that’s the case, price accordingly. Move the price slightly higher and when the person expresses an interest, find a very valid reason to give the discount. Maybe they’re a first time customer, a small business you want to help, or they’re a non-profit.

Lowering prices — also known as implementing a sales discount — might seem like a surefire way to turn heads and generate interest in any business, and in many cases, it can do just that. But there are a lot of layers and potentially negative implications to consider when offering one.

Discounts can often go either way, depending on how well-structured, timely, and drastic they are. So if you're thinking about implementing one, it's important you have a firm grasp on the concept and understand the perks and pitfalls of the practice.

Bottom Line ...

A 10% discount is much more than meets the eye. When you run the numbers at the end of the month, a 10% discount can easily translate to a 50% reduction in profits when adding in overhead, the cost of holding the inventory, and more. For brands (especially online) operating at around 50% profit margin, a 10% discount can be the make or break between flat-lining and making a loss on every single sale.

Although you never want to run a business as if the most important thing is making money, a business isn’t going to be in business very long if you give away the store. Knowing the value of the product or service — especially the value that money can’t buy. When you position it as an investment instead of an expense, conversations change — they begin to move away from price.

What’s the alternative? …

Value added is the extra value created over and above the original value of something.  It can apply to products, services, companies, management, and other areas of business. In other words, it is an enhancement made by a company/individual to a product or service before offering it for sale to the end customer.

Value can be added to a product, service, process, or an entire business. Value can be added by providing better or extra services in the form of after-sales services and better customer support. Value can also be added by improving a product in some way, or by including extras with the product. For example, a retail seller of computers can add value by including software or computer accessories with the basic product – the computer.

Value-based pricing is potentially the best pricing strategy for any brand, your customer relationships and your bottom-line — but as with most worthwhile endeavors, it isn’t considered “low-hanging fruit.

This is why most companies turn to sub-par pricing strategies like cost-plus pricing and competitor-based pricing.

Value-based pricing ensures that a brand's customers feel happy paying the asking price for the value they’re getting. Pricing according to the value the customer sees in a brand’s product prevents the business from short-changing itself, or making a loss, while creating an experience for customers that’s most aligned with their expectations.

The business will also strengthen the brand name, build better customer relationships, and ultimately improve it’s bottom line (profit). Value-based pricing is the only true win-win scenario for you and your customer.


Summary Break Down of Unit Economics

Unit economics and pricing 

  • The impact that discounting has on sales volume, order value and resulting profit. 
  • The impact of offering free shipping to customers on orders over a certain value.

Unit economics and supply chain and logistics 

  • Changes in the supply chain commercials, such as moving to a new warehouse or courier. 
  • Logistics issues prevent orders from shipping out on a timely basis, leading to a higher cancellation rate (for example). 

Unit economics and marketing 

  • The impact of expanding into new markets e.g. a new geographic territory, such as higher delivery fees, import duties or local sales tax. 
  • The effectiveness of the marketing strategy and channels in driving traffic to your website.
  • Changes to a website impacting the customer journey, resulting in fewer sales conversions per visitor.
  • Structuring the profit and loss account (P&L) to segment the various levels of unit economics will help direct you to the areas of the business that need your attention and help you make better strategic decisions. 


Calculating unit economics  

Below are the key data points used to calculate unit economics for e-commerce businesses. Typically, the financial numbers are used in aggregate and divided by the number of orders shipped in the month.  

Data points

Details

(a) Basket order value

The average product sales value per order (pre any applied discounts)

(b) Less discounts applied

Average discount per order

= AOV

Average Order Value

(c) Less refunds

The average refund amount subsequently issued on every fulfilled order

(d) Less landed cost of goods sold

The cost of materials, manufacturing, assembly per order plus any freight and duty incurred transferring each order to your warehouse, ready for sale

(e) Plus returned stock

The average cost of resellable stock returned per order (if any)

(f) Less customer replacements

The average landed cost of goods required to be sent out in replacements per order

(g) Less stock write-offs

The average landed cost of goods damaged or lost per order

= CM1 per order

Contribution Margin 1 per order (also known as Product Margin).

(h) Plus shipping revenue

Average shipping charged to customers per order

(i) Less pick and pack fees

As charged by your warehouse per order

(j) Less delivery fees

The average delivery and duty charged per order by your shipping agent for delivery to customer

(k) Less return fees

Return delivery and processing fees charged per order

(l) Less transaction fees

The commission charged by your website’s payment gateways (e.g., Paypal, Klarna, Stripe, Shopify Payments) plus any variable platform fees (e.g. Shopify platform transaction fees).

This also includes any costs relating to cancelled orders (where an item is refunded before is it fulfilled), which still incur transaction fees.

= CM2 per order

Contribution Margin 2 per order (gross profit after selling and distribution costs).

(m) Less variable marketing spend

The online marketing spend per order, e.g. paid search, paid social, sponsored influencer posts and affiliate commissions. Similar to transaction fees, this should capture the cost of marketing spend incurred on orders which were subsequently cancelled (e.g. total marketing spend / total fulfilled orders (not “clicked” orders)

= CM3 per order

Contribution Margin 3 per order. The total net profit or loss contributed per order after variable marketing costs.

A Summary Example


Here’s a very simplified example:

Let’s say we have a business that sells embroidered robes - Adam’s Robes Co LLC

The item costs $12 to manufacture

It costs on average $4 to warehouse and hold

Pick, pack and materials costs $2

Shipping on average costs $5

Factoring in operating & running costs, as well as failed deliveries (resends), faults, and returns the average cost is $4

Marketing spend and cost of acquisition is $4

Card processing costs 2.5% + 50c

Sales tax on the sale is 20%

  • They sell each robe for $60
  • So the total costs to the business is $45
  • They make $15 profit when they sell one at full price.


In a discounting scenario, if someone ran a 20% discount promotion, the sale price would be $48, and so, rather than make $15 profit per sale, they’re making only $3 per sale.

In reality, they would have to sell a massive 500% more units of robes just to break even (they’d have to sell 5 discounted robes to make $15, instead of selling 1 robe to make $15).

The result was a massive rush of discounted purchases on robes, making the team chaotically busy both in the warehouse and via customer services.

At the end of the promotion, the business had not sold 500% more robes than normal, which they would have done at full price, and so in the same period of time running the promotion, they actually made less profit in the same time span of not discounting, yet were around 400% busier putting a drain on the entire team. A result which meant customer service queries slipped, and social media/marketing slipped - leading to a major lull and drop in sales following the cessation of the sale. It took 5 months to recover.

------------

Now, say Adam’s Robes Co LLC also sell embroidered slippers, and 50% of their customers buy robes and slippers together, so we know they’re a valuable combination, as well as logical.

This year Adam’s Robes Co LLC bought 10 containers of slippers from China at the start of the year at a really, really good price.


Here’s the breakdown:

This item costs $2 to manufacture

It costs on average $2 to warehouse and hold

Pick, pack and materials costs $2

Shipping on average costs $5

Factoring in operating & running costs, as well as failed deliveries (resends), faults, and returns the average cost is $2

Marketing spend and cost of acquisition is $2

Card processing costs 2.5% + 50c

Sales tax on the sale is 20%

  • They sell each set of slippers for $40
  • So the total costs to the business is $24.5
  • They make $15.50 profit when they sell slippers at full price.

Rather than discounting, especially ‘blanket’ discounting everything, they decide to run a value add promotion: Buy two robes (his and hers) and get embroidered slippers for free.


Here’s the maths:

2 Robes and 1 Slippers

The item costs $26 to manufacture

It costs on average $10 to warehouse and hold

Pick, pack and materials costs $4

Shipping on average costs $5

Factoring in operating & running costs, as well as failed deliveries (resends), faults, and returns the average cost is $6

Marketing spend and cost of acquisition is $4

Card processing costs 2.5% + 50c

Sales tax on the sale is 20%

  • They sell the bundle deal for $120
  • So the total costs to the business is $82.50
  • They make $37.50 profit when they sell the bundle on every sale

As an extra bonus, they discovered that where normally 50% of people would normally buy robes and slippers anyway, in this instance, when customers bought the bundle, 50% of bundle buyers added an extra pair of slippers to the order, so they were shipping 2 robes, 2 slippers (only one set of slippers free) probably for the his/her matching motivation.

This means on 50% of the value-add promotion the maths was even better:

2 Robes and 2 Slippers (1 slippers free)

The item costs $28 to manufacture

It costs on average $12 to warehouse and hold

Pick, pack and materials costs $4

Shipping on average costs $5

Factoring in operating & running costs, as well as failed deliveries (resends), faults, and returns the average cost is $6

Marketing spend and cost of acquisition is $4

Card processing costs 2.5% + 50c

Sales tax on the sale is 20%

  • They sell the bundle deal for $160
  • So the total costs to the business is $95.50
  • They make $64.50 profit when they sell the bundle on every sale


As an extra bonus, they also discovered, that this way they moved a lot more stock than normally, as well as their social media shares and traffic to the site increased (due to happy customers sharing their matching his and hers robes/slippers online) and so this allowed them to attract more customers at no acquisition cost, plus, they could order 20 containers of slippers from China with confidence, driving down the manufacturing costs to $1.50 per unit, instead of $2.

Overall, the business exploded in growth by adding value to their customers and to their brand. The value adding promotion never eroded their headline price, and so after the promotion, there wasn’t a drop or lull in sales which typically happens when a discount promotion ends and customers hold off waiting for the next discount promotion.

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