Gross margin is one of the key metrics for e-Commerce businesses, and one of those metrics that businesses tend to be sensitive about. After all, would you reveal how profitable your e-commerce store is to random strangers on the internet?
I didn’t think so. So let’s dive in what Gross Margin is, how to look at it and how you can improve it.
Gross margin is a metric that measures your profits as a share of revenue. A higher gross margin or gross margin rate means that you have a highly profitable business. A lower gross margin or gross margin rate means that you make less profits with each unit sold.
Gross margin is calculated as
Gross Margin = Revenue – Cost of Goods Sold (COGS).
COGS includes the purchase value of your product, as well as any other costs that directly relates to your product such as shipping, import duties and warehousing.
However, marketing expenses, staff costs, and other operating expenses are not included in COGS.
Typically, gross margin is quoted as a percentage of revenue. In this case, it’s known as the “gross margin rate”:
Gross Margin Rate = (Gross Margin / Revenue ) * 100
As an example, suppose you buy furniture wholesale from a supplier in Asia and ship it to the US. Each unit costs on average $100 at wholesale, including shipping costs, and you can sell to your customers at $150. Your gross profit on each sale, therefore, is $50.
This is not your final profit: you still have overhead expenses to cover, but it’s a measure of profitability nonetheless, and a critical one at that.
Your gross margin rate is: ($50 / $150) * 100 = 33%
Now comes the hard part, however. Out of that gross profit of $50, you now have to meet all the other expenses of running your e-commerce business. These include:
- Payroll expenses
- Web development
- Overhead expenses
The list is nearly endless. It all has to come out of your gross margin. If you have a very small gross margin, therefore, you need a high level of revenue to be able to pay all of these and still make a profit.
Why Gross Margin Is Important
So if gross margin is not your final profit – why does it matter so much?
Gross margin tells you whether your e-commerce store is making a profit on each product that you sell.
When gross margin is negative, that means money is lost on each and every sale. So scaling up in that case means that instead of growing into profitability, you are actually deepening the loss with every sale.
Now, if you make a gross profit on each product, but you have a negative net profit, that means that the overhead and marketing costs are too high. That also means that if you scale your revenue and your customer base, your overhead costs would grow less and you would grow into profitability.
Finally, as I’ll explain in a more detail below – having a higher gross margin gives you space to invest. That investment could be in marketing to acquiring new customers, but also in product development, improving your existing products or developing new ones to further strengthen your position in the market.
Gross Margin Benchmark
It’s hard to establish an absolute gross margin benchmark since markets for each product can be so different. A healthy gross margin is one that allows to comfortably pay for all the associated costs of running your e-commerce business, while leaving plenty of income to turn a net profit.
What suits a gaming store won’t work for a supplements e-commerce store. However, the typical e-commerce store has somewhere between 20-60% gross margin.
MarketingSherpa surveyed some e-commerce store owners and found that e-Commerce owners report an average gross margin between 30% and 40%:
Gross Margin & Customer Acquisition Costs
Having higher average gross margins across your store will allow you to spend more on customer acquisition. This can help you outbid your competition for traffic, especially if you rely on paid traffic for sales.
Picture this. Jamie and Mark both run yoga-focused e-commerce stores. They compete for the same customers but Mark has a lower gross margin rate of 10%, whereas Jamie has a gross margin rate of 30%. For every $100 in sales, Jamie keeps $30 after paying the supplier and shipping costs, whereas Mark keeps $10. However, over time, Jamie is in a position to outcompete Mark and grow her business much more rapidly. Why is this?
Mark can only invest $10 after every sale into marketing and customer acquisition, whereas Jamie has up to $30 to spend on this. Both will have to pay other operating costs such as office rent and salaries for employees.
Jamie, however, can outspend Mark on marketing and pay per click ad campaigns by a ratio of 3:1 without losing any money. If Mark were to spend that much on customer acquisition, he would quickly run out of money and go out of business.
This example shows how strong the relation is between gross margin and the overall viability of your business.
How To Improve Your e-Commerce Gross Margin
Gross margin is a two-factor equation. To improve gross margins for your e-commerce store, you can either boost your revenue per product or decrease the cost of each sale. Let’s explore the options below.
If you need an example for boosting your gross margins, you can learn from Nike’s e-commerce playbook. As reported by CNBC, this iconic shoe brand saw a recent boost to profits and company valuation after marked improvements in its gross margins on online sneaker sales.
Nike accomplished this by raising prices on some of its shoes.
To boost margins on the revenue side, you have to find a way to increase your prices. If you have a long list of happy repeat customers who buy from your store regularly, this is easier to do than if you just make one-time sales to customers.
Common ways to raise your prices include:
- Improve your product – Sell a better product at a premium price
- Upgrade packaging – This allows for higher price as perceived value is higher
- Better marketing – showing the value/benefits rather than the features can increase the willingness to pay a premium price
Other strategies that increase total revenue relate to increasing average order value, for example by product bundling, expanding your product range and acquiring higher traffic. However, these strategies do not impact gross margin, so I will cover in other articles.
Cost Of Goods Sold
Lowering your product-related expenses is typically harder to do, but it is still possible. Again, if you accomplish this, your gross margins will go up.
Some of the main strategies to lower the COGS:
- Negotiate a lower purchasing price with your supplier. If you are a repeat buyer and buy in bulk, you could get such pricing concessions. Putting in your orders early or agreeing a minimum quantity for the year may help as well. Another way to get a lower purchasing price is to change the payment terms and pay earlier. But be aware of the impact this has on your cash flow.
- Reduce your shipping costs. This might mean, for example, moving to a lower-cost shipping company.
- Reduce your warehousing costs. One proven method is to work with 2 warehousing solutions – one for the bulk storage that is cheaper, and one for the fulfillment storage. This will increase your workload and coordination costs, but may save a lot from the expensive fulfillment warehouse.
But no matter which route you take, beware any unintended consequences of cost-cutting measures. For example, lower cost shipping companies might take longer to deliver goods to your customers. This could ruin the customer experience and result in lower repeat sales. In the long run, such a move could actually lower profits, not improve them.
This article originally appeared on Abel Finance by Rob te Braake.