Decoding E-Commerce: Unit Economics, Venture Capital, and Why HARDware is HARD

 Contents

1. Introduction

2. Understanding Unit Economics in E-commerce

3. A Quick Calculation for Unit Economics

4. The Domino Effect of Returns on E-commerce Margins

5. The Hidden Sting of Foreign Exchange Rates

6. Navigating Supply Chain Challenges

7. The Role of Indirect Costs

8. Investors and E-commerce: Decoding the Reluctance

9. 11 Strategies and Tactics for a Highly Profitable E-Commerce Business

10. Conclusion

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TL;DR - Summary

• E-commerce must have positive unit economics.

• Calculating unit economics involves understanding direct and indirect costs.

• Unit economics in e-commerce can be surprisingly tight if you run the math.

• Returns, exchange rates, and supply chain complexities can pose additional challenges.

• On average, margins in ecommerce hover at just 10%, which explains why many venture investors stay away from ecommerce and stick to software and content.

• However, e-commerce businesses can throw off tons of cash flow if done right.

• Tactics for improving profitability include optimizing pricing, leveraging cross-selling, using subscription models, automation repetitive workflows, and more.

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Introduction

Today, I'm taking you on a journey into the fascinating world of e-commerce to shed light on a key concept: unit economics. Together, we'll untangle the variety of costs affecting your business's profitability, tackle the challenges faced by e-commerce pioneers, and discover robust strategies to triumph over them. So, if you're setting your sights on a prosperous e-commerce venture or are simply eager to delve into the intricacies of this sector, stay with me as we dive headfirst into the topic!

Understanding Unit Economics in E-Commerce

At its heart, unit economics is a bedrock concept that examines the profitability derived from selling a single unit of a product or service. When it comes to e-commerce, this means dissecting the direct and indirect costs tied to each transaction. If your unit economics are too tight, you might find yourself running a business teetering on the brink of profitability, vulnerable to the slightest turbulence and unexpected happenings – which, let's be real, are part and parcel of life. Conversely, with healthy unit economics, you're empowered to pour profits back into the business, whether it's through investing in customer acquisition via paid ads, assembling a capable team to manage the everyday business operations, or introducing automated e-commerce solutions across different communication channels like email or text.

Now, let's dive into the primary factors shaping e-commerce unit economics and the obstacles that fresh businesses face in this domain.

A Quick Calculation for Unit Economics

Running an e-commerce business involves selling products with a range of direct costs, which significantly influence unit economics and profit margins. To illustrate this, let's imagine we're selling a product for $100 per unit - a slightly pricier end if you're in B2C. Here's a breakdown of some of these costs:

• Value Added Tax (VAT): For US-based businesses, it's common to exclude VAT from the retail price, but in many countries, particularly in Europe, VAT must be included in your retail price. In places like Switzerland, VAT is 7%-8%. In Germany, it can reach up to 19%. Let’s take a 10% VAT for this calculation, so $10 of your $100 sale isn't yours.

• Payment processing fees: Payment processing platforms like Stripe also take their cut. The going rate is typically 2.9% of the transaction value, plus a fixed fee of $0.30 per sale - that's $3 less on every $100 sale. Be mindful that costs can be higher on other platforms.

• Manufacturing costs: Creating your product also means shouldering manufacturing costs, which can vary greatly depending on what you're selling. These costs could be almost nonexistent for digital products, or much steeper for high-quality goods produced locally in the US or Europe. For our $100 product, we'll assume a manufacturing cost of $15, though it could easily be more.

• Shipping costs: Next up, getting the product from the manufacturer to your location (or directly to the customer if you're using drop shipping) also incurs shipping costs. These can range from $5-$10, depending on your product's size and weight. Let's earmark $10 for shipping in our example.

• Customer acquisition: Winning customers through advertising or marketplaces isn't free. For a $100 product, customer acquisition costs usually fall between $10 and $30 per customer. While it might not be much lower, it can certainly go higher - especially during competitive periods where CPMs on platforms like Facebook fluctuate drastically. For this example, we'll use a customer acquisition cost of $25.

Adding these costs together, we find our direct expenses are $63: $10 (VAT) + $3 (Payment processing) + $15 (Manufacturing) + $10 (Shipping) + $25 (Customer acquisition). Subtract this from our $100 sale price, and we're left with a margin of $37 - 37% of our sale price. But 37%, while it may seem decent, can be quickly eroded by other costs, like returns and exchange rate fluctuations, which we'll discuss next.

The Domino Effect of Returns on E-commerce Margins

Returns are a typical part of e-commerce, especially in industries such as fashion. I'm sure we all know someone who's ordered a cart full of items from websites like Zalando, only to return most of them after trying them on and deciding they aren't quite right.

The process of handling returns brings about additional costs, from receiving the returned item, replacing it, and shipping it back out again. From my experience, returns can often be pricier than shipping products to customers in the first place. This is mainly because returns tend to disrupt the standard workflow of third-party logistics providers, especially if they're tasked with picking up the parcel from a customer's doorstep. So, let's assume a total cost of $25 for handling returns, with $15 allocated to the return process and an additional $10 for reshipping the replacement item.

Let's revisit our $100 product. If it experiences a return, the seller's margin is squeezed further to $100 - $63 (direct costs) - $25 (returns) = $12. That's a mere 12% of the sale price, a significant reduction in profitability that brings your e-commerce venture perilously close to running at a loss per sale.

The Hidden Sting of Foreign Exchange Rates

Foreign exchange rates represent a less obvious, yet potentially significant cost. Once payments are processed, the funds will be sent to your chosen account. Unless you've got accounts in the same currency as the payment and preferably in the same country, you're likely to lose money due to the steep fees banks often charge for currency conversion. If not managed wisely, this could escalate into a major cost running into tens of thousands.

Personally, I'm a fan of Wise for their foreign exchange rates, particularly as a retail and small business owner. However, it might not be the most suitable solution for a high-frequency business like e-commerce. Of course, you could choose to hold the foreign currency without converting it, but then you're taking a gamble. Foreign exchange rates can swing wildly - even between 20-30% in a span of 12 months for established currency pairs.

Unless you have expenses in the local currency or can hedge your exposure (a costly and complex operation), you're usually better off converting the money back into your local currency.

Navigating Supply Chain Challenges

Supply chain complexities can add further layers of difficulty to e-commerce operations. Factors like raw material shortages, quality control issues, shipping delays, and fluctuating demand can affect your business's ability to deliver products in an efficient and cost-effective manner.

Chris, my partner in crime at Maison Baum, and I found this out first-hand as we traversed Italy and Spain in our quest to find the best producers for our product at the time. Given we were selling handmade, high-end shoes, we faced particular challenges. Sometimes, to maintain the quality of your product, you might have to partner with a more expensive supplier, which can, in turn, bite into your unit economics.

The Role of Indirect Costs

Alongside direct costs, e-commerce businesses also shoulder a variety of indirect expenses. These can include team salaries, benefits, licenses, rent, utilities, and insurance, to name a few. Keeping these costs in check is crucial, as they can substantially impact overall profitability. It's worth noting, however, that these aren't exclusive to e-commerce businesses - they're a part of running any business.

Investors and E-commerce: Decoding the Reluctance

E-commerce ventures tend to showcase lower profit margins compared to software or Intellectual Property (IP)-based businesses, which can make them less appealing to venture capital investors. According to Shopify, the average profit margin for an e-commerce business hovers around a mere 10%, whereas software businesses can relish profit margins skyrocketing to 70-80%. This stark contrast often deters many traditional venture capitalists from backing e-commerce products directly.

There have been exceptions, of course, with angel investors who might have an emotional or deep professional connection to the product we were developing, or who found the sector particularly enticing. It's also possible that strategic investors might jump aboard - for example, a fashion brand might be interested in investing if you're building a business in the fashion industry. However, the plain-vanilla, institutional capital investors - the traditional venture capitalists - are likely to shy away from the e-commerce product itself. Now, e-commerce infrastructure, like Shopify and payment processors, is a whole different ballgame and highly interesting, but that's a conversation for another day.

Despite these challenges, it's important to remember that it's entirely possible to construct immensely profitable e-commerce businesses if you smartly choose the right niche and structure your company effectively.

11 Strategies and Tactics for a Highly Profitable E-Commerce Business

Here are a few tips I have used or have seen being used to contain cost and improve unit economics, so that you stay profitable even when the unexpected happens:

1. Marketing 101: Use social proof, scarcity, and urgency to push customers towards finalizing their purchases, reducing acquisition costs and increasing the average order value.

2. Pricing strategy: Opt for selling premium products, allowing you to set higher prices and create more room for profit margins. Run price elasticity tests to see the impact of higher and lower pricing on customer lifetime value and acquisition cost. You might discover that you can charge more for your products without increasing acquisition costs or churn.

3. Cross-selling: Encourage customers to purchase complementary products or bundle items to reduce shipping costs and customer acquisition expenses. Many ecommerce-first platforms like Shopify provide functionalities to facilitate cross-sell techniques in the checkout process.

4. Subscription model: By offering subscription-based products, you secure repeated purchases from the same customer, improving customer lifetime value and increasing overall revenue. If you manage to maintain a low churn rate, a subscription-based offering can be a very effective strategy for building a successful ecommerce business.

5. Conversion Rate Optimization (CRO): Optimizing your store's conversion rate can lead to reduced customer acquisition costs. Changing the positioning and labeling of calls-to-action, tweaking the copy and creative on your website, streamlining checkout processes, and proactively addressing key objections and questions can help increase your conversion rate. However, it's hard to predict which changes will be the most effective, so A/B testing can be a useful tool here.

6. Payment plans: Offering payment plans like 'buy now, pay later' (BNPL) can encourage customers to finalize their purchase, as it spreads the cost over time. This can lead to increased conversion rates and lower acquisition costs.

7. Shifting costs to customers: Although difficult, transferring some costs to customers, such as return shipping fees, can improve unit economics. For instance, you might decide to cover the cost of shipping products to customers, but not the cost of returns unless there are demonstrable quality issues with the product.

8. Reducing dependency on ads: Focusing on organic methods like SEO can reduce your reliance on costly advertising. Building an email list and using referral marketing can also help lower acquisition costs by encouraging word-of-mouth recommendations. Other strategies, like affiliate and influencer marketing, can help too, although these methods can still be expensive.

9. Niche down to a clear ICP: In order to reduce customer acquisition costs and your dependency on ads, you should have a clear target audience. This enables you to find the best media buyers and develop winning copy.

10. Offer something for free: Instead of discounts, test how your audience reacts to a free offer. This approach can often be more effective than simply offering discounts.

11. Managing indirect costs: It's important to keep indirect costs like team salaries, rent, and licenses under control. Having a lean team and efficient operations can make a significant difference to your bottom line. Automate as much as possible and work with your accountant to find potential areas for optimization.

Conclusion

Building a successful e-commerce business is all about understanding your costs and how they affect your profits. By carefully looking at all your expenses and using my 11 strategies and tactics, you can build an extremely attractive e-commerce business. So, go out there, look at the numbers, and make your e-commerce business a success. Good luck!