If you’re starting or have recently begun an e-commerce business, you might notice there’s a lot of math involved, especially if you want to grow. Numbers, ick.
What’s more, you likely can’t afford an accountant or analyst. The truth is, you’ll probably have to do this stuff on your own in the beginning.
Of course, you’re not alone. Barring the math whizzes out there, many highly successful online entrepreneurs started with little to no formal finance training. Most were driven by the allure of independence, creating something they believed in, or some other internal motivation.
That said, knowing the financial side of your online shop is the smart thing to do. It will massively increase your chances for success.
More than 50% of small businesses fail in the first four years, and 82% fail because of cash flow problems.
Get this: 89% of the businesses that succeed attribute an having a good handle on the numbers as essential to their success.
Knowing your numbers is the secret sauce.
The sad truth is, many online entrepreneurs don’t know what they’re getting into when they start a business. Many start businesses for lifestyle reasons, ideals, or the dream of building something that matters, all without considering that a business, at its core, is still a business.
Don’t worry, it’s always challenging in the beginning, and you’re not alone.
Tim Berry, Founder and Chairman at Palo Alto Software and Adjunct Professor at the University of Oregon, once recounted a memory involving one of his former students.
“Rose (not her real name) explained how getting her own business seemed to be swallowing her life,” Tim wrote. “She was always worried, always wondering, playing over in her mind the next month what would she have to pay, where would the money come from. There were always questions about if and when she should add people as employees, offer more services and so forth.”
All this anxiety because she didn’t understand her finances. Luckily, she got her act together.
“In her case (I’m proud to say), she had some residual idea of business numbers still lingering from the classroom experience. So she knew where to start looking. She dug up some old explanations of cash flow, and dug into her online bookkeeping, and began to pull apart her last year or so of sales, costs of sales, running costs, fixed costs and cash flow.”
Once Rose had dug back into her schooling and refreshed her understanding of finance, she was able to get a grip on her business.
“At least I know now when I have something to worry about,” Rose said, “... and when I don’t. So it’s way easier now to turn the worry off when things are okay. And when they aren’t okay, I know that early now, so I know when and why to worry and what’s the problem when I have one.”
Do you feel like Rose before she went back to the basics? Are you struggling to understand how much money will come in next month, what you owe suppliers, and why you’re paying so much in fees?
If so, don’t stress. Being apprehensive about things you don’t understand is natural. So let’s get literate together.
Financial advice varies widely depending on the size of your venture and what services you are offering. However, there are some critical metrics to track when running an ecommerce business.
Below we’ll discuss some of the most important terms to know when operating an online business. We’ll start with what I think is the most important metric to understand, Cost of Goods Sold, because it forms the basis for your financial success.
Cost of Goods Sold (COGS)
COGS are the direct costs incurred by producing the products sold in your online shop. If you’re reselling products, COGS is merely the cost of sourcing the goods, storing them, and sales tax. If you’re producing the products, COGS also includes:
COGS excludes indirect expenses like marketing, sales staff, and shipping to customers, which are also known as operating expenses. Once the goods hit your distribution warehouse or fulfillment center, anything afterward is not considered a part of COGS.
Understanding and accurately assessing COGS is critically important for calculating your gross profit.
This one goes without saying, but it’s so important, we’re going to say it. Know what your sales are weekly, monthly, quarterly, and annually. Once your volume increases, you can track daily—and eventually even hourly—sales.
This is your total sales minus your cost of goods sold. It will determine whether or not your business has a chance to succeed from the outset. Obviously, if your gross profit is less than zero, success is not possible. But just having a positive gross profit is also not a guarantee. Your gross profit margin must be sufficient to cover your overhead and operating expenses, and even more than that if you want to invest in diversifying or increasing your product line, for example.
These are all expenses that are not incurred by the production of your product. These are things like:
It’s hyper-important to be aware of all your expenses all the time, even if you have a healthy gross profit. Escalating operating expenses can be your downfall, so make sure to play out different scenarios with various SaaS tools, payroll companies, and advertising channels when forecasting.
With operating expenses, you can then derive your net income.
Net income is your total sales minus total expenses, which include COGS, operating expenses, interest, taxes, and preferred stock (if applicable) dividends.
Total Sales -Total Expenses = Net Income
Knowing your net income will ultimately determine whether or not your business can succeed in the long term. Because, unless you’re building a lifestyle business, you’ll want to maximize your net income as much as possible in the long run.
Average margin is the average amount of profit you derive from your sales over any specified length of time. This represents how profitable your store is considering the average margin of all the products you sell. It stands to reason that your average profit margin will be weighted by the products that are most popular in your online store.
You can use this to project finances into the future. All thing being equal, if you manage to increase sales by 50%, you can easily calculate the profits you’ll earn.
If you find that your average profit margin is too low because you're selling mostly low margin goods, you have to figure out a way to rectify this. Low margin goods can be volatile as markets and business situations change. That’s one reason I advocate making and selling your own products rather than re-selling someone else’s products.
Most Popular Products
You should know which products are your most popular. That will guide you in pushing the sale of similar, but higher-margin products or even complementary products, ultimately boosting your average order value.
The conversion rate is the rate at which website visitors turn into customers. There are two methods for calculating conversion rates, either per visit or per unique user. Both methods will help you understand how effectively you are generating online sales. The conversion rate is calculated by dividing total visits or unique users by the total number of transactions (not revenue).
For example, if 1,000 people visited your site and made 40 purchases, you would have a 4% per unique user conversion rate.
40 / 1000 = .04 or 4%
Alternatively, if those 1,000 visitors visited your site 1,600 separate times but made the same 40 purchases, you would have a 2.5% per visit conversion rate.
40 / 1600 = .025 or 2.5%
You can do this calculation sitewide, but you can narrow it down to a particular product, product category, demographic, or specific user journey.
Monthly Customer Value (MCV)
By calculating each customer’s value over time, you can identify your best customers.
To determine your most valuable customers, divide the total sales you’ve generated from one customer by the amount of time they’ve been a customer.
For example, if Sam has purchased $5,241.98 worth of product from you and he’s been a customer for 13 months, his MCV value is $403.23.
$5,241.98 / 13 months = $403.23 MCV
We’ve calculated MCV over time, as opposed to looking at total sales, because time is critical. Successful businesses are always aware of cash flow, not just total sales.
With that in mind, we can see that from a monthly perspective, Sam has a pretty good MCV (assuming we’re not selling fighter jets). Now let’s say he’s been a customer for 13 years instead of 13 months. The calculation looks entirely different.
$5,241.98 / 13 years OR 156 months = $33.60 MCV
Suddenly, Sam has gone from being one of your top customers to being relatively average or perhaps even below average.
Be sure to calculate MCV using only the time your custom has been active. If Sam hasn’t purchased something in several months or years, he's likely not an active customer anymore, but may still be valuable. This is an excellent opportunity to reach out, find out where he went, and offer him something he can’t refuse.
I’m a firm believer that you ought to reward your best customers as much as possible. When you know who they are, you can send special promotions, gifts, or a simple “thank you,” to make them feel appreciated. Customers that feel special are apt to make repeat purchases and refer others at a much higher rate.
Average Customer Value (ACV)
Your average customer value is similar to your monthly customer value (MCV). However, in this case, you’ll take all your sales and divide them by all your customers. Typically, you will measure this on either a monthly or a rolling 30-day basis, so the figure is continuously changing.
For example, let’s say you generated $14,762.24 last month from 2,109 customers. Your ACV would be $7.00.
$14,762.24 / 2,109 customers = $7.00 ACV
Keep in mind, though, that this methodology is rather blunt. If your data set is small, just a few low-value orders can quickly reduce your ACV, just as a few high-value orders can inflate it. It’s a coarse instrument, but it can be useful.
To remedy this and reduce the weights of uncommonly high or low-value purchases, you could remove the upper and lower 1 to 5% of sales from your data set. We’re wading deeper into statistical analysis by talking about the distribution of your sales values here, but I think you get the point.
This information is useful when thinking about marketing. Assuming you know your conversion rate, mentioned above, and that it costs you $4.00 to acquire one customer, then you’re in business. Buy more traffic if and until it stops making sense.
Alternatively, you can use this information to start a remarketing or email campaign to try to get customers within the last 30 days to make another purchase, therefore raising your ACV.
Customer Lifetime Value (CLV)
CLV is the value of each customer for life, from their first purchase until their last.
Knowing your CLV is incredibly beneficial, but it’s not very easy to calculate. However, one of the best articles I’ve read on the topic is from none other than Shopify. Anything I’d write here would merely be repetition, so I’ll let their article speak for itself.
Suffice it to say that knowing your CLV gives you a better understanding of the long-term health of your business. It shows whether or not you’re building loyalty among your customers — loyalty that turns into repeat business.
There are other metrics worth tracking, many of which deal more with the operations and marketing sides of your business, but we’ll save that for another time. With these fundamental sales and business metrics, you should have a good handle on the financial condition of your store.
The best thing to do once you understand these metrics is to practice using them consistently. Set up a routine for updating, analyzing, and forecasting with these metrics. Only with that practice will it become second nature.
Eventually, you’ll probably hire an analyst to do this, but you’ll be in a much better position to manage that analyst, as well as understand their advice, if you can speak their language and understand what they’re talking about.