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“Watch the costs, and profits will take care of themselves” – Andrew Carnegie, an American industrialist.
While starting an e-commerce business is not as complex as leading the expansion of the steel industry in the USA, the fundamentals remain the same.
Understanding and managing costs pave the path to profitability.
Yet many founders get too excited about a product idea and rush to invest most of their capital without evaluating the feasibility of their venture.
After finding a niche and a product with market potential, they commit thousands of dollars to forming a legal entity, creating branded logos, and buying inventory that may never sell.
That’s a guaranteed way to fail in the current e-commerce landscape.
It’s no longer as easy as launching some crappy ads on Facebook to drive traffic to a mediocre product page and expect profit to start flowing in.
If you plan to start an e-commerce business in 2022, you should instead reverse engineer the path to profitability - start by breaking down costs needed to operate a profitable business in the selected niche.
For any e-commerce business, profitability can be captured by the following formula:
Profit = (Average Retail Price – Variable Costs) * Volume – Fixed Costs
The retail price is determined by the market research and competitive analysis - what is the maximum reasonable price that you can charge for your product given your positioning.
Volume is driven through iterations of testing and optimizations of your paid and organic marketing efforts.
But the purpose of this blog is to focus on the economics of a new e-commerce venture.
As noted above, there are 2 types of costs that you should evaluate before committing any capital:
Let’s look at the step-by-step evaluation.
Assuming that you’ve done your preliminary research into pricing, the first step is to calculate the variable costs to determine unit profitability (AKA unit economics).
In other words, how much profit can you generate from selling a single unit.
The most common variable costs in e-commerce include and are not limited to the following:
The nominal value of the cost of goods sold will vary from business to business, but the main buckets of expenses are:
A low-ticket item like a t-shirt will have a different product cost (wholesale price) compared to a bulky wagon for children.
That also applies to freight and packaging - the larger the weight and size of an item, the more it will cost to ship it from the country of manufacturing or package it to fit the size.
And given the recent and quite notorious challenges with logistics caused by the COVID pandemic, it’s absolutely crucial to estimate the freight bill for imports into the USA beforehand.
The freight amount can range from 15 - 40% of the product cost, depending on the weight of the shipment, the season the shipment takes place, and macroeconomic factors, such as energy prices, labor shortages, geopolitical events (the pending conflict between China and Taiwan can impose significant risks and drive up the costs).
There are plenty of providers that can give you a quote for your shipment as long as you know the dimensions, weight, and total cost of the products, but one of the more reliable tools is Freightos.
Even though their quotes tend to be slightly more expensive than other providers, they guarantee the quote after it’s locked in and offer insurance on the transported goods.
Insurance is a MUST-HAVE item. A lot of businesses are experiencing delays, misplacement, and mishandling of their shipments which lead to damaged or lost inventory.
Adding a freight insurance policy for 1 - 3% of the total value of the shipped goods is the safest investment you can make given the supply chain issues.
Next you need to estimate your import duties.
The total bill will depend on the product type, country of origin, and HS Tariff codes.
For the most accurate and up-to-date information, refer to the USITC Harmonized Tariff Schedule or use a brokerage calculator provided by a broker of choice.
Since there are a number of tariff codes available for a given product, you should explore all tariff codes and find an opportunity to save money.
For example, a dilutable BIB coffee concentrate with a 2101.11 HS Code can fit into several subcategories with different import tax rates, ranging from 0 - 20%. So, finding the right tariff code can be the difference between 0% import duty and 20% off the value of imported goods.
The other customs-related costs that you will have to incur would be the customs bond (annual or single entry), ISF filing fee, CBP clearance, FDA clearance (if applicable), and other processing or management fees if you file via a customs broker.
Customs brokers can charge up to the 3 times the cost of filings, but if you are a tech-savvy person, you can avoid working with a customs broker and complete customs clearance using Clearit USA.
Their interface and features are super intuitive AND they will assign an agent that will help you complete the customs clearance and communicate any issues that arise.
Although it’s a self-serving software, it can help you save thousands of dollars compared to using a customs broker for each shipment. With 10 shipments per year, that can add up to $10,000 in savings to start with.
If you decide to outsource your order fulfillment to a 3PL partner, then you will need to include their rates in your unit economics.
Choosing the right 3PL partner for your business needs is a challenge in and of itself, that’s why we have written a more comprehensive overview of 3PL types in this blog.
But simply put, 3PL handling and fulfillment fees for most 3PL providers average $2.35 - $3 per order, which includes one unit.
If the weight of your product exceeds a certain threshold (most commonly 50 pounds), a 3PL will charge you extra for handling a “heavy” product.
If an order has more than 1 unit, the handling fees will usually increase by $0.25 - $0.75 per each additional unit.
While handling fees may not affect your unit profitability, the extra charges can add up to thousands for dollars per year if you don’t consider your business model and order details - look beyond the unit economics if you expect customers to buy more than 1 unit in each order.
Whether you use a 3PL or fufill orders out of your house, you will certainly incur shipping costs.
Shipping is the biggest margin killer for small e-commerce businesses if done poorly.
Discounted pricing requires volume.
Without volume, the 3PL or carrier will not provide the best possible shipping rates to you.
Plus, shipping to zones beyond Zone 6 can really run up the monthly bill.
The shipping zone will depend on the point of origin, but the distance brackets will usually look like this:
Zone 1: 0-50 miles
Zone 2: 51-150 miles
Zone 3: 151-300 miles
Zone 4: 301-600 miles
Zone 5: 601-1,000 miles
Zone 6: 1,001-1,400 miles
Zone 7: 1,401-1,800 miles
Zone 8: 1,801+ miles
The shipping cost goes up significantly as you move from one zone to the next. For example, the difference in cost for a 20-pound product between Zones 1 and 9 is around $55 - $65, depending on the 3PL or shipping carrier that you use.
Learning shipping rates for each zone is a MUST when calculating unit economics and deciding on whether to offer free shipping or set up zone rates to your customers.
In case of unprofitability, you may be better off not selling to specific zones.
And choosing the location for your main warehouse or distribution center can help expand the reach while also reducing the monthly shipping costs.
When signing up for a Shopify plan, you can choose from 3 options:
Most e-commerce brands start with the Basic plan and then upgrade when the volume of sales or headcount increases.
At that plan, the selling fees will equal 2.9% of each order’s amount + 30 cents.
But Shopify incentivizes e-commerce businesses to subscribe to higher plans with savings in selling fees which can add up to large sums when monthly sales volume increases.
Simply put, $16,667 / month is the sales breakeven point for the Shopify plan and $54,000 / month for the advanced plan at which the savings in transaction fees cover the increase of the monthly subscription.
Until you reach $16,667 in monthly sales, there’s no real financial benefit to upgrade to bigger plans, except for potential shipping discounts.
After taking all these costs into consideration, the minimum gross profit margin (profit after product cost, freight, labels and packaging, import duties, customer shipping, 3PL fulfillment and handling, selling fees) that you should aim for is 50%.
Anything below that threshold will most likely result in your business running losses, accounting for the possibility of emergency expenses, operating expenses, and increased acquisition costs.
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