The key to build a profitable business is as simple as making sure that the revenues generated every month are higher than the costs incurred to generate that revenue.
In eCommerce companies the analysis is usually done on a customer basis: the revenue generated by one customer over its lifetime must be higher than the costs incurred to acquire the customer and to deliver the product or service to that customer. This is usually called Customer Lifetime Value or CLV and it is a measure of the gross profit you expect to generate from each customer.
This is so because looking at monthly numbers in the early days could lead you to the wrong conclusion since in order to build your customer base you need to invest money acquiring customers. That investment will likely be significantly higher than revenues at the beginning. However, if you expect to generate more revenue in the future from that same customer, you need to take that into account while evaluating how much you can invest to acquire a new customer. In many eCommerce businesses it is alright to have acquisition costs higher than the average revenue made from a customer on its first sale because they will recover the investment when that customer comes back again to your website and purchases again.
If your business is such that a customer will only buy once from you then it does not make sense to use the CLV and the profitability analysis is significantly simpler and you will be able to know if you can build a successful business almost from day one.
How to compute the revenues generated by one customer?
Let’s use for our example an eCommerce site that sells shoes.
In order to compute the revenues the average customer will generate on your site you need to calculate or estimate three variables:
- Average Order Value: this is the average value of an order made on your website. If you are running a website you can compute this by dividing total revenue from sales by the number of orders over a given period of time.
- Average Number of Orders: this would be a measure of how many orders you expect to get from one customer during its whole life. Since a customer will always make at least one order, this value will be 1 or higher.
- Return rate: this would be the percentage of returns during the same period you use to compute the Average Order Value. To measure the return rate simply divide the total number of returns by the total number of orders during a given period of time.
With those three values you can compute the net revenue generated from one customer in the following way:
OV x O x (1 - RR)
O = Orders per Customer
RR = Return Rate
OV = Order Value
For example, if your Average Order Value is 60$, the Average Number of Orders is 2.4 and the Return Rate is 7%, the revenues generated by one customer would be $133.92.
In the next post we will look at how to calculate costs.