Is Your E-commerce Startup Measuring the Right Metrics?
Business failure doesn’t come from nowhere. When an E-commerce startup fails, it fails due to reasons that are often easy to see long before everything falls apart. This may sound like common sense, but too few entrepreneurs bear this in mind when they go about the daily business of leading their companies. Operations may appear to be okay while being far from it beneath the surface.
The best way to ensure that your E-commerce startup is thriving is to employ ‘Unit Economics’, descriptive measurements of the current performance of your company. We’re going to follow the journey of two E-commerce companies, both fictional, as they apply or don’t apply these measurements and see what consequences occur.
One day two friends named Michael and Sally both founded their own E-commerce companies, backed by angel investors. They both had found their niche in selling office supplies to major corporations and were ready to see where their respective ventures took them.
They both did their best to make sure that more money came in than went out, and they did fairly well at first.
Sally struggled, however. She had offered all her prospective customers special discounts, gave them free gift vouchers, and provided special access to limited edition products. She was taking any and all opportunities that came her way, yet still she found herself losing money and she didn’t understand why.
Michael, though, had started out by taking a step back and focusing on the stability of his company. He had done so by taking a look at recurring revenues, the predictable patterns of income that helped him make sure that he could keep the lights on as his startup moved forward. He didn’t know it yet, but focusing on his recurring revenues would wind up paying dividends for his company in ways far beyond what he expected.
You see, being able to point to a flat quantity of revenue is excellent, but the ideal is to be able to confidently claim that the revenue will occur next month too and also for the foreseeable future. Doing so not only gives a guarantee of stability for your everyday operations but also opens the door for Venture Capitalists to feel confident about what you do.
What are the KPIs that E-commerce Startups Ought to be Measuring?
Many E-commerce startups today simply lack positive metrics with respect to profitability, but this can be an okay thing. Take-home profit is just an option, an option you shouldn’t always choose. In fact, Sally’s basic mistake was focusing on immediate revenue at the expense of everything else.
The bare availability of profit here and now doesn’t mean that you should claim it at the expense of continued investment in your business. Consider the opportunity cost; is it worth it to take home the money now at the expense of much more money later?
This choice is where unit economics really comes into play. Unit economics looks at the direct revenues and costs associated with the most basic element of a company’s business model. Being in possession of positive unit economics metrics ensures maximum growth and transforms your business into a viable and valuable opportunity for investors worldwide.
As mentioned above, Michael’s startup is doing well because he started off with a strong foundation, a focus on recurring revenues.
You can do this too, no matter what stage of development your startup is in. Which of your income sources recurs on a monthly basis? This is your Monthly Recurring Revenue (MRR). In other words, it’s your more predictable income. To calculate your monthly recurring revenue, you simply multiply your total number of paying users by the average revenue per user.
Recurring revenue is most commonly calculated on a monthly basis in unit economics, but it can also be calculated on a quarterly or yearly basis depending on the needs of your analysis. If you are not sure on how to generate MRR for your company, this book by Robbie Kellman Baxter can help you build a self generating revenue stream.
Customer Lifetime Value (CLV)
One of Sally’s big mistakes was evaluating the profitability of her company based on her growing user base. More is not always better! Sally kept pumping in her startup capital to sustain her growth rates, without factoring in the customer acquisition payback period. Her startup kept needing more and more venture capital to even prove that her e-commerce business could even scale.
When beginning a relationship with a customer you should predict how long the relationship can be expected to be maintained; this is known as the Customer’s Lifetime Value, or CLV. How much value are you getting from initial interaction with a customer? How much is that customer worth in future revenue? Some handy math is available to help you calculate these things:
CLV = (Revenue per User * Gross Margin %) / Customer Churn Rate
After a few months of operations, Michael sat down and took a look at his numbers. He saw that his average customer made regular purchases from his company for four months, averaging about $100 per month. Going by this data he was able to know that the CLV he was working with was $400, and that whatever onboarding expenses incurred per customer had to be less than that number in order for his business to work. That was smart of Michael, don’t you think?
Customer Acquisition Cost (CAC)
Sally took on any and all customers that came her way, barely waiting long enough to study the numbers. She was surprised, though; why was she losing money? She was taking on more customers and that meant more income, right? She didn’t understand what was going on.
Michael, on the other hand, held in mind the Customer Acquisition Cost, or CAC, which is calculated by accounting for any immediate costs associated with acquiring a customer. This includes such things as paid ads or administrative fees. In general it is best to take revenues generated within a given period — a month, for example — and identify how much was spent in terms of costs (both variable and fixed) that went into generating these revenues.
Think of it mathematically: Customer acquisition cost = Total cost of generating the revenues / The number of customers.
A huge chunk of your marketing budget is being spent on user acquisition strategies and with so much competition, customers are less loyal and offer less “return” on the acquisition investment. Keeping this in mind, you have to reduce churn without over-spending on promotions, you need to focus your ad spend on consumers predicted to become high lifetime value customers. As a general rule of thumb, remember that the cost of acquiring a given customer should be lower than the lifetime value of the same customer, and should preferably be as low as possible.
When she first started losing customers, Sally panicked. What was wrong with her company that would cause anyone, anyone at all, to stop giving her business?
Michael, though, remained calm when he first experienced customer loss. He recognized that such a loss is just a normal part of doing business, and he took a look at what the numbers meant for his startup.
Last month Michael’s startup made 100K, but this month with the same cohort he ended up making only 80K. What this means is that 20K churned — the recurring revenue was lost. Michael was thinking about his churn rate, the percentage of customers who have cancelled their service or subscription within a given time period.
Churn rate = (Revenue lost from a cohort in a month)/ (Recurring revenue per month) = 20K/100K = 20%
Michael knew that 20% of the revenues from last month will not come in this month and that is why he used this churn rate to calculate the amount of new revenue that needs to come in so that it not only offsets the loss but also contributes to growth. To state the very obvious: the lower the churn rate, the better. Michael, as you see, took data driven decisions based on the right metrics.
“Calculating churn for e-commerce is trickier, but doable, and well worth the effort. The key difference for non-subscription-based e-commerce companies is that they need to clearly define what constitutes a churn event. For example, if a company knows that most of their customers who will make a repeat purchase do so within 90 days, they may choose to mark any customer who has not made a purchase in that time period as being “churned.””
Whenever you move forward and present an investment proposition to investors, the wiser among them will break down your model into unit economics metrics. Burn rate is another important metric.
Burn rate is the amount of cash that a company consumes each month in order to continue operations. Massive acquisition costs and lower LTV are making startups burn cash at an alarming rate, with zero focus on sustainability. This seems to be a trend with companies that have received a lot of venture capital. Instead of fixing their product, they tend to burn more cash to gloss over the problem areas. However, burn rate is a metric much like profit — it can be negative without deterring investors as long as your overall unit economics are positive. If that is the case then your company is healthy, and that’s what investors want to see!
What are the Lessons Learnt?
Be more like Michael and less like Sally.
Business is about more than turning a profit, but you have to turn a profit to have a business. Profit is the foundation of your startup, your guarantee that you can continue and expand your activities in the future.
App downloads, DAU, MAU, ARPU have long been the benchmark metrics to measure success in the Ecommerce space. While these numbers may be “fantastic”, they are becoming increasingly irrelevant as a measure. The last decade has seen the retail industry go through dramatic changes with the growth of e-commerce and other digital touchpoints. As a consequence of these changes, profit margins are going down while the discounts are going up. The war is no longer about customer acquisition, it is about customer retention.
Startups who focus on the wrong numbers or vanity metrics can easily end up privileging short-term profits over long-term sustainability. In a mad rush to become the number one player in the market, they forget the basic fundamentals of business — make more money than you spend per unit of labor.
What sorts of metrics do you use to track profitability in your own business ventures? Do you have experience with unit economics unmentioned in this article? We would love to hear from you in the comments.
About the Author:
Prachi Gupta is a Content Writer and Tech Blogger at July Rapid, a San Francisco based mobile app design and development studio of July Systems Inc. July Rapid team assists Retail & E-commerce companies to conceptualize and build custom native iOS and Android applications.