Profitability Analysis for Scaling eCommerce Startups

A profitability analysis is critical for more than just tracking your eComm startup’s revenue — it’s important for fundraising and scaling, going beyond basic gross margins to more accurately help leaders determine what products, marketing channels and other strategies are working. This helps spur more informed decision-making, helping reduce costs, optimize pricing and allocate resources accordingly.

Without a proper profitability analysis, many eComm startups may focus on the wrong things or revenue activities that don’t contribute to profitability, which can impact their long-term stability and outlook.

While gross margins are important, they often don’t tell the whole story and can create blind spots for your eComm startup’s business model. This is because they exclude critical operating expenses and indirect costs that are essential to running an online operation, which can mask issues that may be eroding net profitability.

Contribution margin and unit economics are frameworks that reveal core profitability, scalability and long-term sustainability, which is important both to your startup and its investors.

Understanding Contribution Margin for eCommerce

Contribution margin tends to be the best profitability metric for eComm startups. Specifically, the contribution margin is the revenue that remains after subtracting all variable costs (i.e., COGS, fulfillment, marketing costs, fees, etc.) from sales revenue. It helps identify the most profitable products, enables leaders to formulate effective pricing strategies, pinpoints areas for cost optimization, and indicates how well your e-commerce startup can cover its fixed costs and operate profitably. It’s also important to investors, as they assess contribution margin to determine scalability, product profitability analysis, and the potential for bottom-line profits.

A three-tiered contribution margin framework (CM1, CM2, CM3) provides a layered view of profitability by progressively subtracting variable costs from sales revenue. For example, CM1 represents traditional gross profit, while CM2 accounts for a broader set of variable costs. CM3 is the most comprehensive margin, which includes all other direct variable operating expenses to provide a more complete picture of profitability at the unit or product level and support ongoing e-commerce profitability improvements.

Critical Profitability Metrics Beyond Gross Margin

While gross margin should not be overlooked, a more focused metric framework can help drive strategic decisions for your eComm startup. Some of the critical profitability metrics you should be assessing include:

• SKU-level profitability: Determine this by gathering all direct costs for each product and subtracting them from its revenue. Based on profitability, you may consider discontinuing any that are underperforming.
• Customer economics: Shoot for a 3:1 LTV: CAC ratio, which is considered healthy for sustainable growth and strong customer profitability and customer loyalty.
• Channel profitability: This helps determine the profit generated from each sales channel (e.g., your website, marketplaces, social media platforms, etc.).
• Average order volume: This measures the average amount of money spent each time a customer places an order to help your eComm startup better understand spending habits. A high average order volume often means your startup is efficient and profitable and uses resources and covers fixed costs effectively, which is a boost to the contribution margin.

Conducting SKU-Level Profitability Analysis

SKU-level profitability is calculated by subtracting all costs associated with an SKU from its total revenue. Follow this formula:

• SKU Profitability = Revenue per SKU – Total Costs per SKU

To start, gather all available data for each SKU (i.e., sales volume, revenue, COGS, storage, advertising) and subtract these costs from the revenue per SKU to find the profitability. From here, you can identify your best SKUs, defined by high velocity and positive post-ad profit, and your struggling SKUs, which are defined by negative contribution margin and high return rates.

Once you know the profitability of each SKU, you can make more informed decisions. Maybe you determine that pricing needs to change or you can bundle certain SKUs to move products. In other cases, you may need to discontinue certain SKUs if they’re not profitable or no longer align with your brand or industry benchmarks.

Optimizing Your Product Mix

After you gather data on SKU sales, profit and costs, you can categorize SKUs based on their level of performance and make decisions accordingly. For instance, you may find that some SKUs require more market spend, while others may require pricing adjustments. Categorize them accordingly to see where value is generated and guide decision-making on any adjustments:

• Class A SKUs: These represent your top SKUs that account for a majority of your eComm startup’s revenue.
• Class B SKUs: These are SKUs that have high growth potential but require optimization.
• Class C SKUs: These are SKUs that are draining resources and only account for a small portion of your revenue.

Strategies to Improve eComm Profitability

How can your startup improve its profitability? Here’s a look at some strategies:

• Revenue optimization by increasing average order volume through binding and upsells, free shipping offers and more.
• Reducing costs by negotiating with suppliers, optimizing fulfillment costs and working to reduce payment processing fees.
• Focusing marketing on high-LTV channels to improve attribution to identify profitable customer sources.
• Focus on retention over new customer acquisition. It’s up to seven times cheaper to retain existing customers than it is to acquire new ones. Loyalty programs and post-purchase optimization can help with retention efforts.

Pricing Strategy Without Destroying Margins

Strategic pricing is another path to greater profitability, but you must be cautious not to compromise your margins too significantly as you implement it. Two strategies are value-based pricing and constant discounting; the former is based on charging the customer’s perceived value of the product, and the latter strategy involves offering regular reduced prices to stimulate demand and drive sales. Value-based pricing often yields higher per-unit margins and is more beneficial in the long term for high-quality products. Conversely, constant discounting can harm your long-term profitability and can also be difficult to discontinue.

Another strategy is dynamic pricing, where prices increase during periods of high demand. We’ve seen the sports and entertainment industry do this over the years, as artists charge more for their performances when demand is high, and tickets increase for sporting events, particularly for the bigger games or more successful teams.

Your shipping strategy is also an important consideration. Ensure that you set thresholds to maintain a positive contribution margin per order, regardless of the shipping strategy you choose, so you protect both net profit and net profit margin.

Common Profitability Challenges for eComm Startups

All startups face challenges related to their profitability. Some of the key challenges you’ll want to be aware of include:

• Rising CAC costs due to iOS privacy changes that limit data collection and marketing personalization capabilities.
• Free shipping expectations from consumers. It’s estimated that 75 percent of all retailers offer it in some way.
• Multi-channel complexity and need for channel-specific profitability analysis.
• Scaling profitability and challenges involved with achieving fixed cost leverage while maintaining positive unit economics.

Profitability Analysis for Fundraising Success

Investors in later fundraising stages want to see more than just potential out of your eComm startup — they want to see a path to sustainable profitability and robust financial models. On this note, they tend to carefully assess contribution margin trends and LTV:CAC ratios.

Negative economics, declining margins or a poor LTV:CAC ratio are all major red flags. Instead, you’ll want to work to show cohort improvements, SKU optimization impact and fixed cost leverage at scale to tell a story about how your startup is prospering.

Strengthen Your eComm Financial Strategy

For more information on the importance of profitability management and to receive expert financial support for implementing the right financial infrastructure and strategic guidance, contact Graphite Financial today. As an accounting services firm that specializes in working with eComm startups, we can help optimize unit economics, generate earnings relative to your costs more effectively, and prepare for fundraising, similar to what we did with Caraway. Contact us today for more information and to schedule a consultation.

FAQs

What’s the difference between gross profit margin and contribution margin for eComm?

Gross profit margin is a measure of revenue minus the cost of goods sold (COGS). The contribution margin is revenue minus all variable costs, including COGS and variable operating expenses such as shipping and marketing. Think of it like this: Gross profit margin is a measure of profitability before variable operating costs, while contribution margin shows how much revenue is left to cover any fixed costs and generate profit. In an eComm startup, contribution margin tends to be a more comprehensive metric because it accounts for variables that are not included in gross profit margin.

How do I calculate SKU-level profitability for my products?

SKU-level profitability is calculated by subtracting all costs associated with an SKU from its total revenue. To determine this, you’ll need to gather all available data for each SKU (i.e., sales volume, revenue, COGS, storage, advertising) and subtract these costs from the revenue per SKU to find the profitability. Use this formula:

• SKU Profitability = Revenue per SKU – Total Costs per SKU

What’s a healthy LTV:CAC ratio for eComm startups?

A good LTV:CAC ratio for eComm startups is 3:1. This is considered a healthy ratio for sustainable growth. Anything above this often indicates an opportunity to increase marketing spend to acquire more customers. Anything below a 3:1 ratio may suggest issues with profitability that you should address.

How does free shipping impact eComm profitability?

Free shipping can actually have a positive impact on your eComm startup’s profitability by increasing conversion rates, average order value and overall consumer loyalty when it’s done correctly. If it’s not done strategically, it can lead to decreased profits due to increased costs and logistical challenges. Some strategies for managing free shipping include increasing product prices to offset shipping costs, setting a minimum order amount to qualify for free shipping or only offering free shipping on high-margin products.

What profitability metrics do Series A investors evaluate?

Key profitability metrics that investors evaluate during Series A fundraising rounds include annual recurring revenue, customer acquisition cost (CAC), customer lifetime value (LTV) and the LTV:CAC ratio. Unlike fundraising during the seed round, where investors are basically gauging a startup on its potential, they want to see tangible proof of market traction and operational sustainability in later fundraising rounds. For this reason, revenue growth, customer retention and net revenue retention are other metrics they’ll assess using clear key performance indicators.

When should I discontinue underperforming SKUs?

Underperforming SKUs are characterized by low sales, poor profit margins and low inventory turnover rates. Analyze the data and undergo the SKU rationalization process to determine if a specific SKU is harming your brand or no longer serving the market’s needs. If that is the case, then a decision to discontinue it should be strongly considered.

How can I reduce customer acquisition costs without hurting growth?

Reducing customer acquisition costs doesn’t have to come at the expense of growth. It can be done by improving existing channels, working to increase conversion rates and leveraging customers through referrals and loyalty programs. There are various strategies you can implement to achieve this, ranging from more strategic targeting of marketing and sales efforts to implementing programs that incentivize referrals. All strategies should be regularly assessed to determine what’s working and whether efforts need to be adjusted.

What tools track eComm profitability in real-time?

There are plenty of tools an eComm startup can use to track its profitability in real-time. Programs like TrueProfit, ProfitMetrics and Glew can calculate costs and other key metrics to offer a live P&L. Other platforms like Google Analytics 4 and Shopify Analytics tend to be more advanced options that also work to track user behavior and sales performance.