FREQUENTLY ASKED QUESTIONS
An online marketplace is a type of e-commerce site where product or service information is provided by multiple third parties, whereas transactions are processed by the marketplace operator.
Dropshipping is a supply chain management method in which the retailer does not keep goods in stock but instead transfers its customer's orders and shipment details to either the manufacturer, another retailer, or a wholesaler, who then ships the goods directly to the customer.
Margin (also known as gross margin) is sales minus the cost of goods sold. For example, if a product sells for $100 and costs $70 to manufacture, its margin is $30. Or, stated as a percentage, the margin percentage is 30% (calculated as the margin divided by sales).
Markup is the amount by which the cost of a product is increased in order to derive the selling price. To use the preceding example, a markup of $30 from the $70 cost yields the $100 price. Or, stated as a percentage, the markup percentage is 42.9% (calculated as the markup amount divided by the product cost).
Used in a real-life scenario:
If you know that the cost of a product is $7 and you want to earn a margin of $5 on it, the calculation of the markup percentage is: $5 Margin ÷ $7 Cost = 71.4%. If we multiply the $7 cost by 1.714, we arrive at a price of $12. The difference between the $12 price and the $7 cost is the desired margin of $5.
Knowing how to markup your products is one of the most important activities for your business. It's the way a business ensures that they receive the proper amount of gross profit. As you read on, you will see that there are certain industry best practices when it comes to setting wholesale and retail prices in traditional vendor-retailer relationships. These industry standards are somewhat altered when it comes to drop shipping relationships.
For any business, the markup you use (i.e. the amount you add to a cost price to arrive at a selling price) ultimately determines your profit margin (i.e. the portion of the proceeds from sales that you reserve for yourself). You may find that various industries attract a certain range of margins on average. It's a good idea to know what the industry averages are for your particular industry, as these can be used as a guide in determining your margins. Once you set a target margin for your business, then you can adjust product costs and markups to ensure you reach your margin goals.
Since no two businesses are alike, even within the same industry, an effective markup ultimately takes your unique business factors into consideration such as the cost of producing your goods (which are determined by things like the suppliers you use, the scarcity of inputs etc), the type of product you are producing/selling (e.g. whether or not your product is a luxury item), as well as the level of competition in the market.
Traditional Wholesale-Retail Relationships
In the traditional consumer goods industry, manufacturers/producers often double their product's cost (i.e. they apply a 100% markup) to arrive at a wholesale price. Retailers in turn usually double their wholesale price to arrive at a retail price. For the latter, in the retail word, they call this keystone pricing. Some retailers may even triple their prices depending on the type of product and their cost structure. For retailers, costs pertaining to logistics, returns and packaging etc can all impact cost structure. Products with a lower manufacturing and wholesale cost can withstand a higher markup. Very high end products may also be marked up above the average rate. Sometimes your markup is constrained by the level of competition in the market. All these factors have to be considered when determining your markup.
In a dropshipping relationship, retailers do not buy in bulk or hold inventory, but rather pass on customer orders to the manufacturer/producer as they come in. Generally, manufacturers/producers usually aren’t willing to provide their retail partners with their wholesale price for items unless they are buying in bulk. Therefore, in dropshipping scenarios, manufacturers/producers usually add dropshipping surcharges to the pricing they give to their retail partners, making their prices higher than the traditional "wholesale" price. The key to a successful dropshipping partnership is to create a mutually rewarding relationship for both sides.
Courtesy of CHRON
Gross profit and net profit are both legitimate accounting terms – it isn't as if one is better than the other. But when managing a small business, it's important to keep the differences between these two concepts firmly in mind.
Gross profit is the difference between the money you take in from selling goods and how much those goods cost you. It excludes a number of items you'd usually deduct from gross profit to arrive at your net profit. Each term tells you something about your business that you'll want to know.
Calculating Gross Profit
You sell a widget for $10. The widget costs you $4. So the equation to determine your gross profit is as follows: You have $10, but then you subtract $4 to equal $6. The $6 is your gross profit. To formalize this concept, the logic is thus: gross profit equals revenue, minus the cost of goods sold. The cost of goods sold is often represented by the acronym COGS.
The widget sale described here is valid – the gross profit really is $6 – but that's simplistic. Consider, for instance, that you didn't buy the widget. You actually made it in your shop. Let's say that the materials you used to make it cost you $1, and that you sold the widget for $10. Is your gross profit then $9? No, because you spent money to make the widget – that's part of the COGS. You'd also have to include the hourly cost of the labor to make the widget, plus any sales commissions you paid to sell the widget, as well as any credit card fees.
What is Included in Cost of Goods Sold?
Well, then what about your rent? That's a cost, too. You may be surprised to learn that you don't deduct your rent. The reason you don't speaks to the fundamental difference between costs that are included in the COGS and other business expenses that aren't.
Included in the COGS are any costs that vary with production or sales. But fixed costs aren't included, which includes rent – which remains the same, whether you're running your production line 60 hours a week or not at all.
Gross Profit Factors in Direct Costs, Not Indirect Costs
So, to sum up: Gross profit is the revenue derived from sales (or service – whatever customers are paying you for) minus the direct costs associated with buying, manufacturing, selling or shipping the product to your customer. It always excludes certain fixed costs, rent among them.
Determining Net Profit
Net Profit is gross profit minus fixed costs. To determine net profit, you begin with your gross profit figure, then subtract your fixed costs, among them are the following:
- Salaries paid to employees: these are fixed costs because presumably employees on salary are paid the same amount of money each month regardless of how many widgets you sell – a salaried accountant for example.
- Property taxes. Because, again, these are the same regardless of how many widgets you've sold.
- Utilities. While it could be argued that your electricity costs, for instance, may rise to some extent with production, the usual accounting determination is that since these are largely fixed they're more appropriately included in fixed costs.
- Fees paid to professionals, such as lawyers or CPAs.
- Amortization and Depreciation. Both of these are costs intended to reflect the gradual devaluation of assets. Amortization is the term used to reflect this gradual lessening of value with respect to intangible assets – a drug patent, or a patent on a new kind of faucet; depreciation is the same gradual lessening of value, but on a physical asset –a business automobile, for example, or production machinery.
Why You Need Both Net and Gross Profit Calculations
In a sense, gross profit may not be your "real" profit, but you still need to calculate it so you can keep track of how your business is doing. First, because the way you arrive at net profit is by deducting these additional fixed expenses from gross profit. But, importantly, gross profit gives you valuable information about how well your business is moving forward.
For example, your gross profits may be increasing, but your net profits are decreasing. Is that bad? Possibly, but not necessarily. If your sales are ramping up steadily, there may come a point where you will need to move to larger quarters. This will entail not only a higher rent, but also all of the costs associated with moving.
The result will probably be a relatively short dip in net profit. In this instance, however, the figure that tells you how well you're doing is the gross profit, which reflects your increasing sales. In the sales period that follows the period during which you made your move, some costs, such as your moving costs – which you have already paid – will no longer pull down net profit. Although the higher rent on your new quarters remains, larger quarters make it possible for you to further increase production, driving up gross profits that will eventually result in increased net profits, as well.
The Net Profit May Point to Business Problems
On the other hand, in different circumstances, the net profit may tell the real story. For instance, if your sales are rising slowly, but your fixed costs are increasing more rapidly, the result will be a drop in net profit, which in this instance, points to a real problem that can be resolved by increasing your sales at a faster rate, by doing something to contain your fixed costs or by a combination of both.
Courtesy of WooCommerce
Your Customer Acquisition Cost is the average dollar amount you spend to acquire a new customer (i.e., attracting them and persuading them to make a purchase from you).
This is the easiest way to calculate your CAC:
Total Marketing Expenditure (in a month) / Number of new customers acquired
Like calculating your gross profit margin, calculating your CAC means scrutinize your expenses and finding all of those that relate to marketing. Here are a few of the more common costs most eCommerce businesses incur:
- Paid advertising on Facebook Ads or Google Adwords, along with any offline ad spend.
- Software, like your email marketing solution and your popup / lead capturing tools. If it is somehow involved in identifying and capturing a new customer, include the cost here.
- Team members that are specifically involved in marketing — you can allocate either their full salary or a portion based on how much of their time they spend on marketing when calculating your CAC.
Say your Total Marketing Expenditure is $5000 for this month and you acquired 500 new customers with that spend. That means that your CAC is $10.
Now let’s extend this by including some of your other metrics. Say your Average Order Value (AOV) is $100 and your gross profit margin is 20%, which means that your average new customer is worth $20 to you. In this scenario — based on a CAC of $10 — you are acquiring new customers in a profitable way and you have a solid foundation from which to encourage them to make repeat purchases over time (which will increase their lifetime value and profitability to you).
Oftentimes, businesses find that their CAC is out of control and exceeding their gross profit margins. It’s possible to use a loss-leader strategy in the short-term and for some products, but selling your products at a loss over an extended period of time may put your business at risk.
This is what happened to Bento, an on-demand food startup, who saw revenue growing nicely. But the more their revenues grew, the more money they were losing. Instead of growing stronger, their business veered towards a cliff at break-neck speed because they didn’t have either their gross profit margins or CAC dialed in.
Listen to the story of Bento on StartUp
Listen to the story of Bento on StartUp
Once you have a good idea of what your CAC looks like on average, there are two ways to extend your monitoring and insights further:
Calculate your CAC per marketing/acquisition channel. This comparison reveals where you are find your better-qualified customers, which can help you prioritize where you spend your marketing money. To do this, split up the total expenditure and the customers you acquire can calculate your CAC for each marketing channel. Say you do that for Facebook Ads and Google Adwords and determine that their CACs are $5 and $20, respectively. It might make sense to stop the more expensive Google Adwords and invest more heavily in Facebook ad campaigns.
Do something similar for specific products or product collections. This is especially interesting if your products have a wide range of gross profit margins, because you may decide that you can spend more to acquire customers of higher-value products or products with a very high margin. This calculation also helps when implementing a loss-leader strategy, where you actually make a loss on selling some products as a way to lure the customer in and then up-sell them on products with better margins.