Constraints are essential for any business. Not because it stifles creativity but because it sets the parameters which you need to operate within.

Nov 3, 2022

Constraints are essential for any business. Not because it stifles creativity but because it sets the parameters which you need to operate within.

– Mal Chia, Director – Ecom Nation

Back in the early ‘aughts, one of my first startup experiences was with a first-time founder. While brilliant in many ways, when it came to the UX and design of the app, he would rarely provide any guidance and tell designers to “do whatever you want”. Every wireframe or high-fidelity design that was submitted for review inevitably came back with a mountain of criticism and complaints that the designer “doesn’t know what they are doing”.

When I worked in marketing agencies, the same thing held true with clients who couldn’t articulate what they wanted.

Fast forward to now and the same pattern is repeated in eCommerce, but this time with business owners and their agencies seemingly performing well, while in fact the ship is sinking.

Why you ask? It’s usually due to a lack of constraints.

Constraints are essential for any business. Not because it stifles creativity but because it sets the parameters which you need to operate within.

Imagine you are standing blindfolded in a room with one door and I ask you to find the exit. You don’t know how big the room is, what the shape is or if there are any obstacles. While you would eventually find the way out, you would approach the task with a degree of hesitancy.

Now imagine if I also told you you were in the middle of the room, it is square and each wall was 6m. How much easier would that task be?

For eCommerce, not knowing these four key metrics and what they should be – i.e. your constraints – means not knowing strategically what you should be aiming to achieve.

Marketing Efficiency Ratio

Marketing Efficiency Ratio (MER) is expressed as performance media spend as a percentage of revenue. This is all your ad spend plus any other variable marketing costs that change with sales e.g. affiliate commission. Calculating MER is fairly straightforward:

(Total Ad Spend + Affiliate Commissions) / Total Sales = MER

A simple way of looking at MER is:

Total Sales – COGs – Operating Expenses – Variable Marketing Costs = Net Profit

The ‘Variable Marketing Costs’ is your MER and it is usually a good indicator of if your business will be profitable or not. Spend more than you can afford and you’ll lose money but at the same time, spend too little and you risk hampering growth (for more on this, go read Paul Waddy’s post – Johnny, we need to talk about your gross profit).

Ideally, have a net profit target in mind and set what you need MER to be. A set MER target should be your first constraint.

If you are spending at your MER target and aren’t growing then that should trigger you to question if:

  1. You are spending too little;
  2. Your performance strategy can’t scale;
  3. You are bringing in enough new customers

Alternatively, if you are above your MER target and you are growing then check your LTV : CAC ratios.

But more than a reactive tool, it can also be used proactively in a way to model performance. A common question is how much do I need to spend on advertising to achieve a given revenue outcome, calculating a target MER (tMER):

Total Sales (%) – COGs (%) – Operating Expenses (%) – Net Profit (%) = Variable Marketing Costs (%) or tMER

This can be done simply with percentages or with the actual numbers if you know them (you should). Total Sales is equal to 100% then minus your COGs and Operating Expenses as a percentage of those sales, factor in the business taking a percentage of profit and you are left with your tMER. Comparing your tMER to actual MER calculations can allow you to track performance on the fly.

MER can also be used to measure the incremental impact of any new marketing activity.

For instance, you are at 20% MER and want to test out a new channel and decide to invest an additional 10%. In the short term, your MER will increase to 22% until it starts to show a return but ideally what you want to see is MER return to 20%. If it stays at 22% then there has been no incrementality. If it returns to or below 20% then the experiment has delivered proportional or even outsized incremental revenue growth.

New Customer Rate

In most industries, it is cheaper to retain an existing customer than acquire new ones – e.g. subscription services. For eCommerce firms however, in order to grow you need new customers. Look at your new vs returning customer reports and I’m willing to bet that outside of sale periods, the months you are growing, first-time customers are more than half your customers.

The calculation for this one is simple:

New Customers / Total Customers = New Customer Rate

Aim to keep this above 50%, a net flow of new customers should be your second constraint.

Customer Acquisition Cost & Lifetime Value

To understand the full value of Customer Acquisition Cost (CAC) and Lifetime Value (LTV), you need to know them both.

CAC is how much you are paying to acquire a new customer and is a simple calculation:

Variable Marketing Cost / New Customers = CAC

Generally good for every business to know, when you consider your Average Order Value this immediately tells you whether you are paying too much to acquire customers. Too much and you either need to increase purchase frequency or decrease acquisition cost.

Too little? No one ever complains they are paying too little for new customers.

So what about LTV?

For B2B, subscription, etc. this is calculated over a customer’s average tenure, for eCommerce this is easier done as 12 months. The majority of what your customers spend with you will be in the first 3 months, and will usually churn after this period.

While many great apps like Peel Insights and Glew exist to help you calculate CAC and LTV, a quick way to calculate LTV is:

12 month Average Purchase Frequency * Average Order Value = LTV

You can get your Average Purchase Frequency by exporting 12 months of order history and calculating the average number of orders a customer makes in this time.

Now take a look at CAC / LTV. This should be around the target MER or lower as this means you are not overpaying for customers. If it is significantly higher, then you need to put some work into improving lifetime value or lowering your acquisition costs. Getting CAC / LTV into alignment with MER should be your third constraint.

To unlock growth in eCommerce and ensure your marketing is delivering real results, make sure your Exec team, Performance team and Marketing leads understand these important metrics and all their efforts ladder up to them.


Photo by Scott Graham on Unsplash

More to read