This guide will lay out the mindset for running an e-commerce store.
- How to think about the economics of your store and the key metric to focus on (answer: CM3)
- Importance of thinking about customers rather than orders (and setting a Target ROAS or CAC)
- How much to spend on marketing? (answer: CAC = LTV/2 or ROAS = LTR/2)
- The best bidding strategy on Google Ads and Facebook Ads
- What to look at to know your store is running well
Chapter 1: Contribution Margins
We’ll start super simple – but build up quickly.
It’s important to understand your contribution margins – how much of the revenue you get to keep and the buckets for all the costs associated with an order.
There are several costs associated with servicing an order on your site:
- Sales tax (VAT);
- COGS (Cost of Goods Sold – the amount you paid for the goods in the order);
- Cost to store, pick and ship the goods;
- Customer service;
- Card processing fee;
- and a share of Marketing costs.
Let’s look at these costs a little more closely:
The Unit Economics of an Order
Let’s take an example. A customer spends £120 on your site. The customer paid £114 for products and £6 for shipping the goods.
In the UK there is 20% Sales Tax (VAT – value added tax) on both the products and shipping. So once the sales tax has been removed the order value is £100 (£95 products and £5 shipping).
As discussed, not all the £100 of revenue goes into your back pocket.
There were costs to service that order.
Below is an example breakdown of the costs associated with the order.
I’ve grouped packaging, pick and pack, card processing, customer service into ‘cost to process’.
CM3 (Contribution Margin 3)
The light green at the bottom of the bar chart is your CM3. In this example when the customer spends £100 (excl tax) you get to keep £15 (15% of the order value) for your back pocket – 85% are costs associated with winning and servicing the order.
We call this Contribution Margin 3 (CM3).
This is what you want to optimise as it’s this that allows you to pay salaries and make a profit.
CM1 (Contribution Margin 1)
CM1 (Contribution Margin 1) is what’s left after the cost of the goods has been accounted for.
CM1 = Product and Shipping revenue minus cost of goods sold (COGS).
This is an indicator of your core product margin.
You can make CM1 higher by increasing prices; increasing shipping fees; reducing discounts; purchasing the goods for less; or changing the mix of products purchased into higher margin products.
CM2 (Customer Margin 2)
CM2 (Contribution Margin 2) is what’s left after all costs associated with fulfilling the order have been accounted for (think of it as all costs except marketing).
Improving CM2 with the same CM1 is about more efficiency/savings in warehousing, shipping, packaging, customer service and card processing costs.
Aim is to Optimise CM3
The aim is to optimise your CM3 – the money left to pay salaries, office costs etc. Whatever is left after your overheads is your profit.
Your total CM3 in a month is the average CM3 per order multiplied by the number of orders.
A very high CM3 per order but with very few orders = low total CM3.
A very low CM3 per order and lots of orders = low total CM3.
You want a strategy that delivers a good CM3 per order AND lots of orders = high total CM3.
Chapter 2: How to think about Optimising Contribution / CM3
Let’s imagine Bob runs an e-commerce store that sells T-shirts.
Each T-shirt costs Bob £5 to manufacture (Cost of goods of £5) and he sells them for £30 each (excluding tax).
Over the course of the month Bob has 10,000 visitors to his website and the conversion rate to order is 1% (delivering 100 orders).
The average order is for 2 T-shirts (@ £30 each) and there’s a £5 shipping fee. So the average order value (AOV) is £65.
The cost to ship is £5 and the cost to process each order (pick, pack, store, packaging, card processing etc) is £5.
The unit economics (or unit stack) looks like the above. Bob makes £45 CM2 per order (what’s left before marketing costs).
His total CM2 from his 100 orders in the month = £45 * 100 = £4,500
Kate’s T-shirt store
Kate runs an identical website but she prices her T-shirts at £20 each.
Because of the lower retail price the conversion rate is much higher at 3%, so she has 300 orders a month (10,000 x 0.03 conversion).
Kate’s unit stack looks like this:
So the average order value is £45. After COGS, shipping and costs to process the order she makes £25 CM2 per order (versus Bob’s £45 CM2 per order when the T-shirts cost £30 each).
However the total CM2 (CM3 before marketing costs) across all orders in the month is £25 * 300 = £7,500 (versus £4,500 for Bob whose T-shirts are priced at £30).
So in this example the higher conversion rate means that the lower priced T-shirts actually generate more overall CM2 for Kate than Bob (66% more in fact – great!).
Chapter 3: What about the Marketing Cost?
Let’s now consider the marketing cost.
For both stores 5,000 monthly visits come from ‘free sources’ such as Organic search and 5,000 visits come from paid sources (such as Facebook Ads or Google Ads) at an average cost of £0.50 a click.
Therefore the total marketing spend in the month for both Bob and Kate = Clicks x Cost per Click = 5,000 * £0.5 = £2,500
Bob’s store with marketing spend (£30 T-shirts)
For Bob, the blended marketing spend per order (this means the marketing spend spread across paid and free orders) is £2,500 / 100 = £25 per order:
So Bob’s CM3 per order is £20 and his total CM3 across all orders = £20 x 100 = £2,000
Kate’s store with marketing spend (£20 T-shirts)
For Kate, the blended marketing spend per order is £2,500 / 300 = £8.33 (because Kate’s conversion rate is 3 times higher than Bob’s, her marketing cost per order is three times lower than Bob’s).
So Kate makes £16.67 CM3 per order.
Across all 300 orders Kate makes £16.67 * 300 = £5,000 total CM3
So Bob makes £2,000 CM3 (with his higher priced T-shirts) while Kate makes £5,000 CM3.
Kate makes 66% more CM2 than Bob but 150% more CM3 (and CM3 is the key metric as it’s what goes into your back pocket).
We are starting to unpick that there is a pricing sweet spot that generates the most CM3. Price too high and your conversion suffers and your marketing spend per order is too high. Price too low and your CM3 per order is low.
Chapter 4: Blended vs Paid Cost per Order
So far we have looked at blended marketing cost (applying the marketing cost across all orders, free and paid).
Remember however that half the orders came from ‘free’ visits and half came from paid visits.
Let’s attribute the marketing cost to just the paid visits and orders:
For Bob’s store the total marketing spend is still £2,500 (5,000 clicks @ £0.5 per click).
The 5,000 paid clicks have a 1% conversion rate which delivers 50 orders.
The marketing spend per paid order is £50 (£2,500 spend / 50 paid orders) which means each paid order has a CM3 of -£5 (i.e. you lose £5 on every order).
That doesn’t sound good.
Let’s look at Kate’s Store where we sell T-shirts at £20 each.
The £2,500 marketing spend delivers 150 orders, so the marketing spend per paid order is £16.66.
This delivers a CM3 per order of £8.34 – so we make money on each paid order – much better.
This conclusion assumes we can perfectly attribute an order to a paid or free channel. You will probably find that a lot of customers visit your site multiple times before purchasing – potentially coming from different sources for each visit (known as the customer journey).
Most companies will decide on an approach/model for allocating the credit for an order to a particular channel, known as an attribution model.
Read more about attribution
Read more about channels
Chapter 5: Cost per Order vs Cost per Click
It’s dangerous to focus on Cost per Click.
Let’s look at Bob’s marketing spend again.
He spends £2,500 to generate 5,000 visits @ £0.5 a click.
With a conversion rate of 1% Bob gets 50 paid orders with a marketing spend of £50 per paid order – meaning he makes -£5 on each order (CM3 = -£5).
Let’s look at the marketing spend in more detail:
Bob runs three different Google Ads campaigns:
The ‘Beach T-shirts’ campaign delivers the most clicks (3,500) and the lowest Cost per Click (£0.41) – however, because the conversion rate is low (0.57%) the marketing spend per paid order is £71.75 driving a CM3 per order of -£26.75 (he loses £26.75 on each order – yikes!)
The ‘Organic T-shirts’ campaign however has a cost per click twice as high (£0.84) yet because the conversion rate is over 4 times better at 2.5% the marketing spend per order is much less at £33.60 – giving him a much healthier £11.40 CM3 per order.
This is an example that focusing on cost per click is a bad idea – The campaign with the much more expensive cost per click is the one that drives profitable orders!
[This example focuses on the varying value of particular keywords, but for a specific search term you should be allowing Google Ads to spend more on users that it thinks will have a higher chance of converting to an order. Read more about how to how Google Ads bid]
So by only running the Organic T-shirts Campaign (turning off the other two campaigns) Bob can move his CM3 per paid order from -£5 to +£11.40.
Across free and paid channels Bob now gets 75 total orders in the month but his total CM3 goes up from £2,000 to £2,535 as we have eliminated the unprofitable orders (£45 CM3 for each of the 50 ‘free’ orders and £11.40 for each of the 25 paid orders).
Hold on though – perhaps Bob can get the ‘Beach T-shirts’ campaign to work without changing the T-shirt price or on-site experience.
Bob needs to target the people that are more likely to convert – moving to a ROAS bidding strategy will help. If already on a ROAS bidding strategy then he might be able to apply a max CPC to reduce crazy bidding from Google; or turn off any ad groups that have a ROAS significantly lower than the campaign average.
Focusing on Cost per Order is better than Cost per Click
Cost per Order = Number of Clicks x Cost per Click / Conversions
Cost per Order is a much better metric to focus on because it encapsulates conversion and cost per click – i.e. it’s OK to pay a high cost per click if there is a high conversion rate. Similarly low conversion rate can be OK if the cost per click is low.
It might be that people on a particular device, using particular keywords, website visit history, demographic are more likely to convert: high conversion is good.
Cost per click gives you no insight into the quality of the traffic coming to the site. Having a really low cost per click that drives people who don’t purchase is a waste of money.
CTR (Click Through Rate)
Click Through Rate (CTR) is another metric that people focus on – but there are caveats with this too.
CTR is what % of people that see your ad (an impression) click on it.
Improving CTR means more volume which is great if your campaign delivers profitable orders but not so great if your campaign delivers unprofitable orders.
The incremental volume might be people less likely to convert too.
So before focusing on CTR make sure your campaign is profitable.
A side benefit is that a high CTR typically reduces your CPC as ad platforms reward ads that get a response from the audience (in Google Ads you get a higher Ad Rank).
However, if people bounce (only look at one page) or have low dwell time (don’t stay long) when they click on your ad then that’s a negative signal for Google.
So remember, CTR is about volume not quality. For a campaign that has fantastic conversion and CM3 then you want as many people as possible to click on the ad.
However, if the ad has terrible CM3 then you don’t want people to click on it until you’ve improved it’s conversion rate.
What Cost per Order to aim for?
For paid orders to be profitable the average cost (marketing spend) per order must be less than the average CM2 (when Marketing spend per order = CM2 then CM3 is zero).
So targeting a cost per order that is lower than your CM2 means you will on average have profitable paid orders.
To work out what Cost per Order to target you really need to understand lifetime value – which means how much a customer is worth based on their first order and repeat orders.
Chapter 6: Repeat Orders
What about Repeat Orders?
Some of Bob and Kate’s customers will make repeat orders. Repeat orders are great!
Someone who has purchased from Bob’s store before is likely to have a higher conversion rate on subsequent visits (great!)
A repeat purchaser is also more likely to have come via a free channel, such as direct, organic search or email (great!)
Let’s assume the average customer to Bob’s store makes 2 orders in their lifetime (you can decide how long a ‘lifetime’ is. Most stores look at either 2 or 3 years).
Let’s take one customer. The first order is from a paid channel and the second order via email. Both orders are for two T-shirts with an order value of £65.
As we saw earlier, the marketing spend per paid order on Bob’s store was £50. With CM2 of £45, Bob loses £5 on the first order (CM3 = -£5).
On the second order there is no marketing cost, so the CM3 = CM2 = £45
So across the lifetime of the customer Bob makes -£5 + £45 = £40 CM3
So when looking on an order basis Bob was losing £5 per order but across the customer’s lifetime, Bob makes £40 CM3 on that customer.
How to square this? 50 of the 100 orders a month Bob gets are from ‘free sources’ – where did these orders come from? A lot of them would have come from customers placing repeat orders where Bob had acquired the customer through a paid channel.
Chapter 7: Customer Life Time Value (CLTV or LTV), Cost of Acquisition (CAC) and Target ROAS (Return On As Spend)
To make money (CM3) from a customer we need the total CM2 across all the customer’s orders to be more than the marketing spend on that customer (across all orders)
The sum of all a customer’s orders’ CM2 is called the Life Time Value (LTV) or sometimes the Customer Lifetime Value (CLTV).
Another way to think about this is that Lifetime Value equals the total revenue from a customer (called the lifetime Revenue or LTR) minus all the costs of getting them the orders (except marketing).
The lifetime value (LTV) of a paid customer at Bob’s store = CM2 of first order + CM2 of repeat orders = £45 + £45 = £90
So if Bob wants to make money (CM3) he needs the Cost of ACquisition (CAC) of a new customer (plus any repeat marketing spend) to be less than the LTV.
So Bob wants the total marketing spend on a customer to be less than £90 over the customer’s lifetime or he won’t make any money.
If Bob has an average CAC = LTV = £90 then he acquires lots of customers but makes no money on any of them (for simplicity I’m rolling any repeat marketing spend into CAC).
If any individual customer costs Bob more than £90 to acquire than he will lose money on that customer.
We can say the maximum CAC Bob should be willing to pay is £90 which equals the LTV (why would you ever want to lose money on a customer?)
At an average CAC of £90 Bob makes no CM3 as the total marketing spend = total CM2
If Bob does not do paid advertising then his CAC = 0 but he gets no paid customers so again he makes no money.
So Bob wants his CAC to be somewhere between zero and the LTV. A reasonable target CAC is LTV/2.
What CAC should you aim for? Let’s understand the demand curve better:
Currently Bob runs three campaigns.
If Bob just ran the ‘Organic T-shirts’ campaign (shown in green) he would get 25 orders at a cost per order of £33.60. To get another 5 orders he runs the ‘colourful T-shirts’ campaign (blue) but they cost £44 each. To get more orders he runs the ‘Beach T-shirts’ campaign (red) which gets him another 20 orders but they cost £71.75 each.
For Bob’s business (and all businesses) the demand curve is not elastic.
This means Bob can’t keep acquiring more orders for the same cost per order.
Within a campaign the cost per order will typically go up if he chases more orders (e.g. he gets 25 orders from the organic T-shirt campaign at £33.60 a order. If he wants to get 30 orders from that campaign then it may cost him £40 an order).
This means that each additional customer you acquire is slightly more expensive than the previous customer.
When you have an average CAC of say £30 that doesn’t mean it cost you exactly £30 to acquire each customer.
Some customer would have been acquired for less than £5 and some for more than £60 (and this is all simplification anyhow, let’s not forget that the customer technically only cost you their click but you have to bundle in all the clicks/views from the people who didn’t purchase).
The high cost to acquire the next customer gets lost when averaged out across the cost to acquire all customers.
Say you acquire 100 new customers in a month at an average of £10 each.
You then push marketing harder and now drive 200 new customers at an average of £15 each.
The additional 100 customers did not cost £15 each to acquire but £20 each (on average). [100 customers @ £10 each and 100 customer @ £20 each ⇒ 200 Customers @ £15 each]
Again, that is a simplification – The 101st customer may have cost £13 and the 200th customer £30.
In theory you want to keep acquiring customers until your last customer’s CAC = LTV (under the premise that it’s worth having a customer that only makes you say £1 over the customer’s lifetime than not having that customer).
There are two problems with this, firstly, pushing your marketing spend such that your last acquired customer’s CAC = LTV pushes up the cost of acquiring the cheaper customers too (you are bidding on each individual user search – Google assigns an implicit likelihood of a user converting. If you want to win more auctions by appearing absolute top more frequently then that click is going to cost you more) – i.e. pushing harder is not just about acquiring incremental customers, it will push up acquisition cost on your cheaper customers too.
Secondly, it’s very difficult to measure what the CAC of your last customer is!
Bob’s Paid orders include new and repeats
Another complication is that Bob’s Paid Orders will include some new customers but also some repeat orders.
Repeat customers tend to convert better than new customers but Google will bid more aggressively on a repeat order as it thinks correctly that the conversion rate will be higher.
Chapter 8: Say hello to LTV/CAC
A more helpful metric is LTV / CAC.
Think about CAC as what you pour in and LTV as what you get back.
If you have an LTV / CAC of 4 then for every £100 you spend on acquiring a customer you get £400 of CM2 back over the customer’s lifetime ⇒ £300 CM3 (£400 CM2 less £100 marketing).
The higher the number the better return you get on your investment, but the fewer customers.
Blended LTV / CAC
If you calculate your LTV / CAC across all your channels (free and paid) we call this Blended LTV/CAC (blended as you are combining your ‘Free LTV / CAC’ and your ‘Paid LTV / CAC’).
For your free channels the CAC may be zero (though you can attribute costs to lead generation, content generation, technical SEO, email creation etc.)
The great thing about Blended LTV/CAC is that there is no attribution debate – it’s calculated across all channels.
Paid LTV / CAC
For Paid channels we can set a Target LTV / CAC. There is an optimal LTV / CAC that drives the most absolute CM3 (where CM3 per customer x number of customers is highest).
We think LTV / CAC = 2 is probably not far off that optimum. If your distribution of orders versus CAC is a normal distribution (see diagram) then your Target CAC is half your Maximum CAC (Maximum CAC = LTV) – with a perfect distribution the last customer you acquire you would break even on.
How to calculate your CAC to account for repeat orders
CAC includes the cost of marketing associated with that customer across all their lifetime orders.
Let’s return to the Bob’s store example. The average customer makes two orders in their lifetime with total LTV of £90. The first order is paid by definition. Let’s say on average half the repeat orders are paid and half free and the estimated marketing spend per order is the same for new and repeats.
The Target CAC = LTV/2 = £45.
The average customer has 1.5 paid orders in their lifetime so the Target CAC for an order is £30.
The simplicity of LTV and CAC – it tells whether you should be spending more or less
Target CAC tells you how much you should spend on acquiring a new customer.
If your actual CAC is more than your Target CAC then you should reduce your marketing spend. If your actual CAC is less than your Target CAC then you should increase your marketing spend.
Not all Customer Groups have the same LTV
You need to decide how to group your customers and track LTV. You may find that customers in different geographies have very different LTVs (perhaps because of different AOVs, repeat frequencies).
Or there might be different LTVs by category (customers buying sports shoes might be worth more than those buying sports socks) and different LTVs by channel.
If you sell your own brand as well as third party branded products you may find the LTV of own brand products is much higher – both because of probably higher margins but repeat rate might be better too if customers can only purchase these products from you (forced loyalty!).
Track LTV on a too detailed level and it becomes overwhelming (plus if you are too granular there is not enough data to see trends). You need to work out the most sensible split for your business that is manageable.
The aim is to make LTV higher
By making LTV higher, each customer becomes more valuable and you can therefore spend more to acquire each customer (your Target CAC goes up).
The higher your Target CAC the more new customers you can compete for and win and the business grows fast as you get more new and repeat customers.
The best way to have higher LTV is to improve the number of repeat orders. This is one of the reasons that Amazon is so focused on customer experience – ease of discovery, clarity on delivery etc. – as it helps bring people back to the store to order again.
Promotions and discounts can help, as can focusing on acquiring email addresses so you can email your customers and leads to tempt them back to your store to purchase.
Making the Average Order Value higher helps as well. This can be done through ‘add-on’ purchases – nudges to buy something additional through good merchandising and promotions.
Product and company reviews give customers confidence to purchase.
Quite often when you give the customer a discount or better value they actually spend more (something we didn’t factor in to the Kate’s store example above – in reality she may have sold on average 2.5 T-shirts per order vs 2 for Bob)
The aim is to make your marketing spend be as efficient as possible at your Target CAC – This simply means that you want to get as many new customers as you can at your Target CAC.
Set a Target ROAS rather than Target CAC
We think setting a Target ROAS is even better than setting a Target CAC as it can reflect the order value and treat higher spend customers as more valuable than low spend customers.
In Bob’s store example LTV for people buying T-Shirts is £90. The first order CAC was £30. The AOV was £65 therefore the Target ROAS would be £65/£30 = 216.67%
Read how to optimise your Google Ads campaigns
Segment your Marketing Spend
For you to accurately track your CAC you also need to segment your marketing spend into its objective (purchase, lead gen, brand awareness etc.), region, product category, brand/non-brand etc.
This segmentation should be boiled into your campaign nomenclature – you can use a tool like mapflo to help join together all your marketing spend and then categorise and sort.
When calculating Paid CAC we want to focus on the Purchase spend. When calculating Blended CAC we should include all marketing spend.
>>> Read our step-by-step guide to optimizing Google Ads
>> Purchase an ANALYSIS OF YOUR GOOGLE ADS ACCOUNT
The interactive video below highlights some of the analyses we cover:
Please be really careful making changes to your Google Ads account
- Google doesn’t always respond how you (or we) think it will. The way we think about Google Ads may not be the best set-up for your account.
- Only change one thing at a time.
- If possible, always use an experiment to test a change – particularly for significant changes such as moving bidding strategy to Maximize conversion value (Target ROAS).
- Protect your financial downside by testing with limited spend in the experiment/change. Note that moving to a smart bidding strategy requires a learning phase where Google may not be efficient.
- Be careful if adding/removing primary conversion actions – changing what Google is converting to can radically change what and who Google targets and how much it’s willing to spend.
- Remember, all changes to your account are at your own risk. Mapflo shall not be liable for any damages; losses; lost revenue or lost profit.
Glossary of Terms
AOV = Average Order Value
CM1 = Contribution Margin 1 = revenue minus COGS (cost of goods sold) in an order.
CM2 = Contribution Margin 2 = margin on an order after all costs directly attributable to that order such as COGS, shipping, payment fees, customer service etc. (except for marketing).
CM3 = Contribution Margin 3 = CM2 less marketing spend. An ‘Estimated CM3’ value uses an assumed CM2 %.
CPA = Cost Per Action. In this report taken to mean cost per conversion or cost per order.
Keywords = words or phrases (assigned to an ad group) that match a user’s search term and trigger Google to bid to show an ad.
Lifetime CM3 = CM3 from all orders (or subscription payments) for a customer.
Profit = CM3 less all fixed overheads (such as salaries and office rent). Hence Optimising CM3 also optimises profit at the same cost base
ROAS = ‘Return On Ad Spend’ = conversion value divided by cost. A ROAS of 400% means you get four pounds of revenue back for every pound of ad spend.
Search term = the word or phrase that a user searches for on Google.