How to calculate and boost your eCommerce profit margin

Date
October 12, 2022
Category
Finance
Written by
Ash Read

Profit margin is one of the most important signifiers of a strong eCommerce business that’s built for long-term success. This metric indicates whether or not your company can stay afloat — you’re either heading towards the rapids on a leaky raft or a sturdy, stable canoe.

Understand how to accurately calculate your profit margin so you can maintain healthy margins for your eCommerce company. Then, you can pull some levers to increase your overall profitability — without just raising product prices.

Identify which type of profit margin to measure

At the most essential level, a profit margin is a calculation of how much money your business makes, and it’s usually expressed as a percentage. But there are different ways to measure profit margins, each accounting for different underlying factors and contributors.

Gross profit margin

Gross profit margin tells you your profitability ratio after subtracting your cost of goods sold (COGS). This metric shows you your profits before deducting other key business-related costs, such as utilities and payroll.

Your cost of goods sold includes materials, manufacturing costs, inventory, and labor costs associated specifically with producing your final product. Those are the only expenses you’d subtract from your revenue for the month — or whichever period you’re calculating.

Why gross profit margin matters: You’ll figure out how much you’re profiting per sales dollar, an important indicator of business health. Without a high gross margin, you can’t absorb other costs of doing business.

When to use gross profit margin: You’re looking to see how efficiently you can turn over inventory into cash for the business.

Net profit margin

Your net profit margin tells you your profitability ratio after factoring in all of your expenses. It’s probably the truest indicator of your profitability and how much profit you have to either take home or invest back in your business.

Net profit margins tell you whether your company makes enough money to cover the full cost of doing business. You’ll subtract all of your expenses from your revenue — this includes COGS, operating expenses, interest on financing, taxes, and any other overhead.

Why net profit margin matters: Net margin tells you how much net income you’re generating, if you’re generating enough in sales to cover all of your expenses, and if your forecasting is accurate.

When to use net profit margin: You need to understand your true cash flow from month to month and how much you’ll have on hand to reinvest for your working capital cycle or longer-term investments like expansion.

Operating profit margin

Your operating profit margin tells you your profitability ratio after deducting your operating expenses from your revenues.

Basically, all expenses before taxes and interest are included in operating expenses because that’s what you need to operate your business in a given month or cycle. You’ll factor in all of your expenses like COGS, payroll, utilities, marketing, and research & development (R&D), then subtract that from your revenue to get a final calculation.

Why operating profit margin matters: Operating margin indicates whether or not you’re bringing in enough revenue to cover all of your operating costs, not just the cost to produce your goods.

When to use operating profit margin: You need a more consistent look into your margins. Operating margin paints a cleaner picture than your net margin because bulk expenses like taxes, financing debt, and interest can take a larger toll from one month to the next.

Use reliable formulas to determine your margins

For each profit margin formula, you’ll subtract the relevant expenses from your revenues. Then, you’ll divide by your total revenue and multiply by 100 to come up with your margin, expressed as a percentage.

Gross profit margin = (Revenue – COGS / revenue) *  100

For example, an eComm company selling outdoor furniture sees $20,000 in monthly revenue, and its COGS is $5,000. Gross profit margin = 20,000 – 5,000  / 20,000 *  100  =  75%

Net profit margin = (Revenue – COGS – rent – utilities – marketing – payroll – interest – taxes / revenue) *  100

Let’s say the same company also has $1,500 in rent, $500 in utilities, $2,000 spent on marketing, a payroll of $4,000, interest of $500 on a loan, and taxes of $1,400.

Net profit margin = $20,000 – $5,000 – $1,500 – $500 – $2,000 – $4,000 – $500 – $1,400 / 20,000 * 100  =  25.5%

Operating profit margin = (Revenue – COGS – rent – utilities – marketing – payroll / revenue) *  100

In that case, the calculation would be:

Operating profit margin = ($20,000 – $5,000 – $1,500 – $500 – $2,000 – $4,000 / 20,000 )*  100  =  35%

Compare to industry benchmarks

Calculate your current profit margin, as well as your profit margins going back over the last six months if you have that data available. From there, you can compare month to month and calculate your average over that timeframe.

Compare your benchmark to the industry average to see how you’re measuring up, set goals to help you stay competitive, and support long-term business health. According to NYU, online retail typically sees gross margins of 41.54% and net margins of 7.26%. They also provide net and gross profit margins across dozens of specific industries if you want to find a more targeted niche to measure your margins.

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Make a plan to grow your eCommerce profit margin

Once you know what your profit margin is, you can take steps to actually grow it so you can sustain your business for the long term. These three methods will help you increase profitability without just raising prices.

Increase average order value

When you’re selling more items per order, you’ll increase the amount of revenue you bring in for each sale.

Higher average order value (AOV) improves profit margins because one customer is purchasing three products instead of three different customers purchasing one product each. Your customer acquisition cost (CAC) is less to achieve the same amount in sales, which helps improve your margins.

Encourage customers to spend more by adding suggested items and recommendations at checkout or on product pages for similar products. Include minimum order incentives, like free shipping or coupons off their next order. You can also run sales or specials on higher-margin products, where you can afford to eat some cost.

Invest in internal product development

Purchasing another brand’s products to resell in your store offers limited opportunity to improve profit margin. Develop your own products in-house to gain full control over your COGS and inventory expenses.

If you’re reselling products from other brands, the price will be set by the original manufacturer. You’re just purchasing the final inventory, so you have little control over pricing. There’s nothing you can do to increase margins except raise your own prices.

Go For Zero
Go For Zero launched its our branded products to increase margins.

Go For Zero’s founder, Ellie Degraeve, realised this issue. So, Go For Zero launched its own branded products by listening to customer feedback and bringing product development in-house. Now, 10 of the top 15 selling items in its store are Go For Zero products. Consult with product developers yourself and pay attention to customer reviews to make your own product launches a success.

Reduce COGS and supply chain expenses

COGS is subtracted from every profit margin formula because it’s the most fundamental expense related to your product. One of the most efficient ways to improve your margins is to optimise your spending.

Negotiate discounts with your manufacturers for paying inventory orders up front. Even a 1–2% discount can quickly add up, especially on larger IOs. Also, ensure you’re paying invoices on time to suppliers and freight forwarders so you can avoid late fees piling up.

Finally, look for affordable shipping options, especially as supply chain strains drive up freight costs. Find a partner who will negotiate rates on behalf of a large group of companies for a discount instead of trying to negotiate on your own.

Healthy margins start with efficient inventory management

The costs to develop, produce, and ship your product will inevitably impact whether your business is profitable or not — but inventory management is not just about the expenses. Manage your entire inventory life cycle to further protect your margins.

Work closely with your manufacturers overseas to build great relationships and develop a quality product that your customers will love. Plan ahead, especially for your busiest seasons, to anticipate peak demand so you can fulfill orders and boost sales. And don’t fund inventory orders with financing that will sacrifice your margins and the long-term health of your business. Learn how to finance inventory efficiently.

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Written by
Ash Read
Ash is Head of Content at Wayflyer and is passionate about DTC and eCommerce.

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