What is eCommerce? Mathematically explained

Let’s see if we can develop a golden formula that mathematically explains all aspects of eCommerce. Like any other business, the objective of an eCommerce website is to make a profit. Luckily, the formula for calculating profit is fairly simple. The formula is:

Revenue is the money generated through selling your products and services online. Cost is all the costs of doing the business, like the cost of goods sold (COGS), shipping costs, storage costs, packaging cost, customer acquisition cost, the total cost of ownership (TCO) of an eCommerce platform, and more. When you subtract business costs from your eCommerce revenue, what remains is your eCommerce business profit.

For Example, this month, your eCommerce store’s sales were $50,000. You bought the products from the manufacturer for $20,000, paid $12,500 for shipping, packaging and storage, spent $7,500 on google ads, and your developer updated a patch on your website and billed you $800 on top of your $200 regular hosting fees. So your cost for this month is $41,000, and your profit is $9,000. 

The formula suggests that you need to increase the revenue generated by the website and lower the associated costs for having more profit. 

Average Order Value (AOV)

Now let’s break down the revenue. Mathematically speaking, we can formulate the revenue of an eCommerce website by:

The formula indicates to increase the revenue; we should increase the number of orders and/or increase AOV.

You will see in a moment how we get to the revenue formula by defining and inversing the Average order value equation. Average Order Value (AOV) is a critical metric representing the value of an average order within a period of time. To calculate the average order value, simply divide total revenue by the number of orders in a specific time.

In our example above, let’s say we had a total of 1,000 orders in that month. $50,000 divided by 1,000 equals $50. So our monthly AOV was $50. Simply said, customers, on average, spend $50 on your website each time they place an order.

AOV is one of your eCommerce website's most important key performance indicators (KPIs). This metric helps you better understand your customers’ buying behaviour, evaluate your overall internet marketing tactics and wisely set your pricing strategies.

For example, you realize lack of free shipping on your website is the biggest reason behind high cart abandonment rates. At the same time, remember we said you need to reduce the costs; you can not provide free shipping for all of your orders. So you come up with the conclusion that you need to set a bar to offer free shipping. Now the question is, what would be the threshold? How much should customers spend on your website to get free shipping? Knowing your AOV will become handy here. A good rule of thumb is to offer free shipping on purchases that are slightly above your AOV.

Conversion Rate (CR)

Besides AOV, another critical metric to measure the success of your online store is conversion rate. And no, we are not talking about religion. In general, the conversion rate is the percentage of users who take a specific desired action. In our case, the conversion rate is the percentage of visitors who purchase something on the website.

The conversion rate measures what happens once visitors are at your website. It allows you to measure the performance of your website, understand how friendly is your user interface (UI) designed and gauge the effectiveness of your user experience (UX) strategy efforts. 

We can formulate eCommerce sales conversion rate as below:

In our example, let’s assume 40,000 people visited the site during the month. We also said that 1,000 users purchased something from your website during this month. Thus, your site's conversion rate is 1,000/40,000 X 100% = 2.5%.

You are probably asking yourself how well you are doing with a 2.5% conversion rate. Conversion rate is relative and varies considerably depending on the business type, your industry and the products you are selling. But as a benchmark, average eCommerce conversion rates are usually between 1% to 3%. During the dot-com bubble around the year 2000, eCommerce sites typically had an average conversion rate of 1%. A decade later, eCommerce sites conversion rates averaged around 3%. In 2018 the average conversion rate for eCommerce sites in the United States was 2.63%.

Now, let’s see if we can replace the number of orders with our new metric in our revenue formula. We can say:

Thus:

Revenue Per Visitor (RPV)

The above formula suggests that we should increase the website’s traffic and increase the conversion rate and average order value to increase the revenue. However, we should be careful with this. If we see a decline in CR by increasing the traffic, we are not bringing in the right traffic. Also, we may take some pricing strategies that increase the conversion rate but, on the other hand, encourage the visitors to purchase lower-priced items and hurt AOV. Or, in reverse, we may up-sell too hard our higher-priced items and increase the AOV but lose a majority of people making a purchase, resulting in a decrease in conversion rate. In a nutshell, we should always take strategies that improve the overall sales, not just a single metric.

That is why if you want to monitor the whole big picture, a composite metric that represents an interaction between Conversion Rate and Average Order Value would be more reliable. Revenue Per Visitor (RPV) combines these two key performance indicators into a single metric. 

RPV shows how much revenue each unique visitor brings in a specific time.

Therefore:

We can replace the Revenue with the earlier formula that we came up with:

So: Revenue Per Visitor (RPV)  = Number of visits X Conversion Rate (CR) X Average order value (AOV) / Number of visits

As you can see, using RPV involves both CR and AOV and leads to a real-world picture of what’s happening with your eCommerce website without blind spots.

eCommerce Golden Formula

If we go back to the original revenue formula and put it in the profit equation, that leads us to our golden eCommerce formula:

In our example we can calculate our eCommerce profit by (40,000 X 0.025 X $50) - $41,000 = $9,000.

Why is it a golden formula? Because in my opinion, it explains all the aspects and activities around the eCommerce world. Take a deeper look:

• Traffic: This part explains all the strategies and channels that drive traffic to your eCommerce website like SEO, SEM, Social media, Email marketing automation, content marketing strategies, etc.

• CR: This part suggests improvements in all activities related to increasing the conversion rate like A/B testing, UI/UX improvements, analytics and event tracking, promotions and pricing strategies, decreasing cart abandonment rates, product testimonials, shipping, and return policies, user personalization, search optimization, etc.

• AOV: This part defines all the strategies to increase average order value like upsell, cross-sell, price control, free shipping and volume discounts, product recommendations, AI, etc. 

• Cost: The last part considers all the efforts to reduce expenses like the cost of goods sold (COGS), customer acquisition cost, packaging and shipping costs, storage costs and eCommerce platform selection to reduce total cost of ownership (TCO), etc.