The gross margin calculation of sales minus cost of goods sold is a fundamental key performance indicator of any business that sells products. It measures the profit generated from each product you sell. It is something that many small ecommerce merchants overlook when they focus exclusively on revenue growth or volume.
There are many factors that influence your gross margin. This article examines some of the ways you can optimize it to meet your business objectives. Notice I said “optimize” and not “improve.” Simply improving your gross margin may lead to lower overall profits as your sales volume may decrease.
Most ecommerce businesses operate with a gross margin of 20 to 50 percent. That range may be greater depending how you price individual products, what your overall product mix is, what your sales channels are, what you pay for individual products, and other factors.
You can generate the same amount of overall profits with a 20 percent gross margin that you can with 80 percent by selling a much higher volume. Many marketplace sellers are pleased with a 20 percent gross margin. Most have a very high sales volume and a very lean operation that is highly efficient.
Conversely, companies with an 80 percent margin are likely niche manufacturers or distributors with lower volumes that target the high end of a specific market. They will have more margin from product sales to cover other expenses, but the size of their market may be much smaller or limited by their pricing strategies.
It’s important to set a target for your gross margin and manage it carefully. That process will allow you to more accurately budget to support your organization, infrastructure, and operations.
Let’s examine this in more detail. The key variables that you control are:
- Sales channels;
- Merchandising and promotion.
Each one is worth further discussion. All are important in developing your optimal gross margin.
Key strategies for selecting products to sell are (a) determining what your prospects want buy, and (b) selling a mix of products that have a chance of achieving your target margin.
Start with the products your target customer wants to purchase. Low-to-mid range products will have a much higher sale potential, but will likely have more competition, which could produce lower margins. Higher-end products, meanwhile, will cost more and your markup may be less than expected.
This brings us to your overall product assortment. This is extremely important. As evidenced by the larger retailers, carry a wide assortment of similar products. This will attract different shoppers. Offering a low-priced alternative makes the mid-range item look upscale. Having a much higher-end offering makes the mid-range product look like a great value.
Another strategy is private-labeling your own brand. Invest in UPC codes and branding, and package them as your product. This will provide an exclusive sales opportunity and offer a way to increase your margin since you will direct competition.
In my previous ecommerce jewelry business, we tried to target products that we could buy cheaply and then label them under our own brand. We targeted the mid market with a 100 to 150 percent markup, to achieve a gross margin in the 60 percent range. This was far superior to branded items that we purchased with margins of 30 to 40 percent.
Your pricing strategies should support your product decisions. Consumers increasingly price shop — from inside a physical store, on a mobile device, or on their desktop computers. Consider pricing-automation software to at least track competitive prices. You don’t necessarily need to match prices since there are other ways to add value.
For example, I recently shopped for headphones on Fab.com. I assumed the headphones were an “exclusive offer,” at a low price. As it turned out, I could have purchased them through several other channels, including Amazon, for 25 percent less. I ended up buying from a lower-priced alternative, not Fab.com.
You may need to adjust pricing to make your target products more attractive. You may want to price a lower-end product slightly higher than the norm so it is closer to the price of the items you really want your shoppers to buy. That will make them more likely to see it as a good value and spend a bit more to get it. Or, if your margins are high on your luxury items, you may want to discount them to attract more luxury buyers.
You may need to adjust pricing to make your target products more attractive. You may want to price a lower-end product slightly higher than the norm so it is closer to the price of the items you really want your customer to buy.
Your pricing strategies should also consider shipping. A $10 product that is offered with $5 shipping is most certainly a $15 product to today’s consumer. If she can buy it for $12 with free shipping from Amazon, you will likely lose.
This is another variable that is underutilized. You want the lowest possible cost of goods. Shop relentlessly for lower cost suppliers. That means having many suppliers to choose from and being able to purchase at the lowest price. Buy in volume and negotiate a higher discount if possible. Go straight to manufacturers, avoiding the middleman.
Sales Channels and Marketplaces
Manufacturers have many available sales channels: direct sales, online sales, distribution, and marketplaces. Their gross margins have the potential to be high since their cost of goods sold are relatively low. This allows them to sell through distribution channels.
Online resellers are likely to have lower margins. This will limit resellers’ sales channels. If you are selling in a 15 percent fee category on Amazon, that immediately reduces your gross margin. Remember, when you sell through channels, your gross margin starts with the revenue you get from the sale, not from the selling price to the customer. Amazon and other marketplaces take their fees off the top; you never see them.
As you expand into new channels like marketplaces, sell products that meet your gross margin objectives. Marketplaces typically require more pricing maintenance to stay competitive and get into the Amazon buy box, where you will have the best chance of making a sale. Most ecommerce merchants sell only a portion of their products in marketplaces. Smart ones select products based on the marketplace itself.
Merchandising and Promotions
The variables here are (a) how you present your individual products, and (b) how you present the overall assortment of products in that category. Make sure, for example, to emphasize the features that differentiate your products beyond price. Consider reviews and ratings in your store so consumers don’t sneak off to Amazon to do more research and never come back.
Merchandising also includes promotions, categorization, and personalization. You can influence buying behaviors through your merchandising tactics. This is growing in importance, as more online stores use personalization to present products that a given consumer is more likely to buy. Never show a high-end customer your low-end items, for example. You could start with your mid-range products and up-sell to your high-margin products instead.