It Has No Impact On Margin, So Now What?

Yesterday I shared this little tidbit from a company:

• Gross Margin Percentage, 1st Order = 53.9%.
• Gross Margin Percentage, 26th+ Order = 50.2%.

This prompts a reader to ask:

• "Kevin, so what? Margin percentages are essentially the same. It's irrelevant."

On a $101.00 average order value, it is relevant.

• $101.00 * 0.539 = $54.44 Gross Margin.
• $101.00 * 0.502 = $50.70 Gross Margin.

It means that best customers are giving up $3.74 of gross margin ... per order.

When you consider that a typical e-commerce brand is producing 5% to 10% pre-tax profit on an annual basis you don't want to just give up essentially HALF of it at an order level by being careless with your gross margin dollars.

Stop being careless with gross margin dollars.

Start protecting profit, ok?

How Do We Treat Our Customers? It's Interesting

In any Hillstrom's Profit project, we take a look at how customers are treated along the customer life-cycle.

Here's how one company generates differing metrics along the customer life-cycle.

Price per Item Purchased:

• $32.08 first order.
• $30.63 second order.
• $30.28 third order.
• $29.91 fourth order.
• $29.86 fifth order.
• $29.19 6th-10th order.
• $28.46 11th-15th order.
• $27.69 16th-25th order.
• $26.98 26th+ order.

Gross Margin Percentage:

• 53.7% first order.
• 53.6% second order.
• 53.7% third order.
• 53.9% fourth order.
• 53.8% fifth order.
• 53.5% 6th-10th order.
• 52.9% 11th-15th order.
• 52.1% 16th-25th order.
• 50.2% 26th+ order.

Percentage of Items Sold Below Their Historical Average Price Point.

• 50.9% first order.
• 52.9% second order.
• 53.1% third order.
• 53.2% fourth order.
• 52.9% fifth order.
• 53.9% 6th-10th order.
• 55.5% 11th-15th order.
• 56.7% 16th-25th order.
• 59.9% 26th+ order.

How are first-time buyers treated? Expensive items at high margins, paying full price.

How are best customers treated? Less-expensive items at lower margins via discounts.

I know, there's a fraction of the audience that will suggest it is fine to tickle the buying bone of best customers with best prices. Sure. But that also means that Management is happy to let profit just drip out of a hole in a bucket. Eventually, that kind of behavior comes back to haunt Management.

Looks Good On The Surface

Here's a sleepwear category. On the surface, sales look good, they're increasing.

But "how" are they increasing?

In the past three years, we've seen a huge change in how sales are generated.

• Items selling at/above their historical average, new items ... -72%.
• Items selling at/above their historical average, existing items ... +8%.
• Items selling below their historical average, new items ... -70%.
• Items selling below their historical average, existing items ... +106%.

Oh oh.

Three years ago about a quarter of what was sold was existing items at a discount.

Today, about 60% of what is sold is existing items at a discount.

So the sales gain is mostly meaningless.

It's hard for the CRM folks to measure their lifetime value stuff and make judgments about how much to invest in marketing channels if they have no idea how the merchants are playing around with margins. Things might look good on the surface, but drilling down just a little but changes the story (in this instance).

Somebody Made a Bad Decision

Here's our Category Margin Summary for Outerwear.

The category is dying, isn't it?

There's a secret to the poor performance ... look at sales of existing items by year.

• $4.2 million three years ago.
• $3.4 million two years ago.
• $1.4 million one year ago.
• $1.8 million last year.

Let's also look at margin percentage for existing items by year.

• 51.2% three years ago.
• 51.0% two years ago.
• 45.2% one year ago.
• 36.6% last year.

To me, it looks like the Outerwear merchant made a bad, bad decision. It's like s/he decided to throw away the existing assortment ... discounting the living daylights out of what was left. However, whatever was newly introduced didn't resonate with the customer (sales of new merchandise increased two years ago and then held flat and are now in decline). This happened two years ago, and the results have not been positive. Well, they weren't bad for a year.

We can see the problem in the upper-left portion of the table. Look at annual sales of existing items selling at/above their historical average ... $1.9 million to $1.7 million to $0.4 million to $0.4 million. The merchant just stopped selling existing items at full price. S/he clearly discontinued existing items.

Now look at the bottom right portion of the table ... total margin dollars by year ... from $5.9 million to $6.7 million to $5.1 million to $4.5 million. The merchant made a bad decision ... one that worked for a year and has now caused damage to the category.

This kind of stuff is happening at your company, too. This kind of stuff hurts conversion rates, hurts email click-through rates, hurts your cost per order in search. It hurts you, the marketer. You don't want to be accountable for stuff the merchant causes.

That's why you have to analyze your business in this manner, correct?

Breaking Down Profit - The Category Margin Summary

Here's a four year Category Margin Summary for Outerwear. This is a new table you have yet to view.

How is Outerwear performing? Not so good.

Sales dropped from $12.2 million two years ago to $9.5 million today.

Look at items selling At/Above their historical price vs. Below their historical price. Look at sales of new items vs. sales of existing items.

There is something that REALLY stands out here ... it's the secret behind this category. Take a look at the table, and I'll share the secret tomorrow.

Meanwhile, A Thriving Category!

If there is negative news, there's likely to be positive news somewhere else.

Here is a category that grew from $13.0 million three years ago to $18.7 million last year. This category is on the move!!

Existing Category Buyers:

• Rebuy Rates improved from 21.9% three years ago to 23.2% today.
• Spend per Repurchaser improved from $107.58 to $134.70 in three years.

Existing 12-Month Buyers, No Category Activity Past Year:

• Rebuy Rates improved from 7.0% three years ago to 7.6% today.
• Spend per Repurchaser improved from $90.16 to $110.92 in three years.

New/Reactivated Buyer Counts and Spend:

• Counts improved from 52,895 three years ago to 64,626 today.
• Spend per Repurchaser improved from $86.06 to $108.60 in three years.

Existing buyer rebuy rates are up 6% ... twelve-month buyers with no twelve-month category buying activity are up 9%, and new/reactivated buyer counts are up 22%.

Not only is this category having healthy gains ... but it is having healthy gains among the least-engaged customer segments.

This is what success looks like!

And among existing category buyers, share of spend within the category has increased from 8.8% to 10.9% in three years.

And that's where the story turns.

Look at what happened in the past year for prior category buyers in all other categories:

• Rebuy rates dropped from 59.8% to 56.5%.
• Spend per repurchaser decreased from $276 to $255.

So the category is thriving, but customers buying from the category are walking away from the rest of the brand. This isn't always the case, but is a bad sign for the rest of the brand.

Customers exhibit interesting behavior. They can love one category but be turned off by the rest of the brand. Make sure you figure out what is driving customer behavior and act upon it, ok?

A Dying Category

There's so much going on in this Category Buyer Analysis. Here we go.

Let's look at sales by year ... it's a negative trend, from $1.8 million to $1.6 million to $1.5 million to $1.4 million. The category is dying.

How about those who bought from the category in the past year? Their rebuy rates are consistent over time (19.2% then 17.8% then 19.4% then 18.9% last year). Existing buyers are going back to this category. If they buy? Their spend improved over time ... $74.08 three years ago, then $78.19, then $85.32, and $92.16 in the past year.

• Rebuy Rates are mostly steady.
• Spend per Repurchaser Improved Significantly.

Existing buyers are not the reason why this category is dying.

How about all of the other 12-month buyers ... those who have not purchased from this category in the past year?

• Rebuy Rates are dying ... from 3.9% to 3.6% to 3.3% to 2.9% last year. The rest of the customer file (i.e. the majority of customers) are walking away from this category.
• Spend per Repurchaser increases ... $58.02 to $58.25 to $62.70 to $67.74 last year.
• The multi-year rebuy trend (-27%) does not offset the multi-year spend increase (+17%).

New/Reactivated buyers?

• 26,555 three years ago to 22,547 to 20,532 to just 16,743 last year.
• Oh boy.
• The multi-year trend is -37%.

What is the multi-year rebuy/buyer trend by customer type?

• -2% for existing buyers (but +2% for all other products).
• -27% for 12-month buyers without purchase in the category in the past year.
• -37% for new/reactivated customers.

This is what dying categories look like. Prior buyers are the last to fold - those with no attachment to the category walk away first.

You also have to wonder if the marketing team is causing part of this problem? You have to ask the question. For instance, if the marketing team won't spend money on keywords tied to this category because margins are low (they are low for this category compared to other categories), then the marketing team is contributing to the problem, albeit with profitable intentions.

A few additional tidbits.

• Gross Margins were 41% three years ago, they are now 37%.
• Price per Item Purchased was $31.24 three years ago, now is $41.88.
• Somebody raised prices over time, achieved unfavorable results, then started discounting to bring customers back.

This category had 74,246 customers three years ago. It has 54,017 today. The category is dying. This is where Merchandise Forensics work comes into play - you perform a deep dive into this category to understand why the category is performing so poorly.

Silos / Profit

Here's what the vendor tweet said:

• "78% of CEOs expect marketers to grow sales, and you grow sales by tearing down silos."

These are the kind of comments that grill my cheese.

"Silos" of course are labeled by vendors as departments within "brands" that overlap functions. I'll give you an example. Back in 2002 at Nordstrom, I was in charge of Database Marketing, reporting to the CMO. Meanwhile, I worked with a peer, a VP in charge of Credit Marketing / CRM and Database Development. She built what was at the time maybe the best customer marketing database in the industry. She was also responsible for executing credit marketing promotions ... it was entirely likely that each week my team would send a marketing promotion for accessories to a customer and at the very same time her team would send a credit marketing promotion to use points on accessories to the customer. Complete and unfettered duplication of efforts.

Each of us operated in a Silo.

Vendors HATE it when "brands" operate via silos. Outside of the obvious "signaling" they do to communicate that "brands" are dumb, there are sales reasons for the contempt ... it's easier to sell to one person than to convince two people with similarly-aligned goals to agree to work with a vendor.

Vendors also provide solutions that allow for marketing integration ... they allow two "silos" to combine, with software executing "integrated" campaigns. If different departments are doing directionally similar things, well, the full capabilities of the software are not maximized.

The statement "you grow sales by tearing down silos" is so fundamentally flawed it is silly.

You grow sales by coming up with creative ideas that resonate with a customer to the point where the customer buys something from you that the customer didn't intend to purchase. Since that is really, really hard to do, we tend to gloss over it and focus on tangential nonsense that is easy to implement.

Creative ideas that increase sales at a rate that exceeds the cost required to implement the idea ... that's what profit is all about. Ignore when a vendor who has a sales team and a product development team (i.e. silos) tells you to change your org structure by eliminating the very structure they already employ when selling to you.

Future Value, Measured Two Different Ways

Here's our example from yesterday.

Here's some of the raw data from the cohort that purchased 26+ times, life-to-date.

Next 12 Month Net Sales:

• $1,072 for Low-Margin History.
• $961 for Avg-Margin History.
• $943 for High-Margin History.

So, on the surface future value looks better for the low-margin cohort.

Now we move on to 12-month gross margin dollars.

• $433 for Low-Margin History.
• $532 for Avg-Margin History.
• $573 for High-Margin History.

We see a different story, don't we?

Two different metrics, two different outcomes.

Which customer would you prefer to Develop?

Eventually, Margin Matters at a Customer Level

I segmented customers based on historical gross margin percentage, then segmented customers again by life-to-date orders. Finally, I measured future gross margin percentage for each combination of segmented customers. The results are outlined in the graph below.

After a first purchase, low margin customers generate lower margin than higher margin customers, but the difference isn't huge ... 53% for low margin customers, 58% for high margin customers.

After a second purchase? 52% vs. 59%.

After a third purchase? 52% vs. 59%.

6th - 10th purchase? 49% vs. 60%.

11th - 25th purchase? 47% vs. 61%.

26+ purchase? 40% vs. 60%.

I know, you have those "loyal" customers you love and some of them generate two-thirds the profit of other comparable customers. You'd rather have some non-loyal high-margin customers, wouldn't you?

Also notice in the graph that there isn't much of a difference between high-margin customers and average-margin customers, in terms of future margin percentage. They key differentiator is low-margin history ... and low-margin history (for this brand) is a function of low-margin categories coupled with discounting and then applied to loyalty promotions.

Rebuy Rates Can Lead To Misleading Strategies

I'm reviewing Category 21. Look at this.

• 19.8% rebuy rate among 12-month category buyers, repurchasers spend $201.55 each.  104,463 buyers in the segment.
• 5.5% rebuy rate among non-category 12-month buyers, repurchasers spend $162.48 each.  844,019 buyers in the segment.
• 31,962 new/reactivated buyers spending $150.93 each.

The data tells you to focus on existing category buyers, as they have the best rebuy rate and highest spend per repurchaser.

But the number of buyers in each segment matter. Here's where annual share of sales come from:

• $4.2 million from existing 12-month category buyers.
• $7.5 million from non-category 12-month buyers.
• $4.8 million from new/reactivated buyers.

Nearly half of annual sales come from non-category 12-month buyers. There are a lot of buyers in this segment, but paired with a low repurchase rate you get a lot of sales volume.

This is a common outcome, folks. We are continually told to focus on our best/loyal buyers. At a category level, outside of Dominant categories, the math changes ... you want to cross-shop customers.

Margin Profiles

I've talked about this a little bit - you can see how marketers impact gross margin dollars.

Let's look at gross margin percentages ... first for Category 06:

• 51.4% for Category Buyers.
• 52.3% for Non-Category Buyers with 12mo. Buying Behavior.
• 51.8% for New/Reactivated Buyers.
• 51.8% total average.

This is common. This is what happens when specific customers are not targeted.

Let's look at a different category ... Category 19.

• 37.7% for Category Buyers.
• 44.4% for Non-Category Buyers with 12mo. Buying Behavior.
• 46.4% for New/Reactivated Buyers.
• 43.3% total average.

This is also common. This is what happens when the marketing team decides to take 20% off when marketing the product to prior buyers.

Now, you can do some math and figure out how much more responsive your existing category buyers have to be to make the discount pay off (in the above case, it's about a 20% lift). If you can generate the same amount of gross margin dollars without harming future value, sure, discounting "can" work.

Make sure you run margin profiles for different customer segments within a category ... see if you are negatively impacting profit.

Where Do Your Buyers Come From?

When analyzing Customer Development within Categories, certain truths about "how" a category develops emerge.

In my recent analysis, I analyzed Category 17.

• 2,316 buyers were prior 12-Month Category Buyers.
• 10,394 buyers had not purchased from the category in the past year but were 12-Month Buyers.
• 6,483 buyers were New/Reactivated.

The way this category grows is to cross-shop other customers into the category.

Now, let's look at the story for a different category. Here is Category 16:

• 14,574 buyers were prior 12-Month Category Buyers.
• 36,725 buyers had not purchased from the category in the past year but were 12-Month Buyers.
• 35,439 buyers were New/Reactivated.

Category 16 skews more toward New/Reactivated Buyers than Category 17.

Here is Category 09:

• 156,363 buyers were prior 12-Month Category Buyers.
• 63,899 buyers had not purchased from the category in the past year but were 12-Month Buyers.
• 97,242 buyers were New/Reactivated.

Category 09 truly owns customers - nearly half of the customers who buy from the category bought from the category last year.

You'll hear merchants talk about "my customers". For dominant categories, that is certainly the case.

The story is different for other categories. Some categories "borrow" customers from other categories. Some categories deliver new/reactivated buyers. Know what the purpose of each category is, ok?

Carmenere Weekend

In the world of wine, I'd imagine that Carmenere is a "Complementary" category.

It's not something you find easily at your local Safeway. But ... yum!!

Complementary categories support Dominant categories. Your favorite Cab is part of a Dominant Category. A Complementary category requires a customer to likely love the rest of your offering as well as the Complementary category.

Complementary categories are perfect for events, as outlined above from Reininger Winery (click here). Complementary categories lend themselves to "reasons" that the customer should buy something. Cabs or Merlots are always available, they're everywhere. But the Complementary category? That's for special events ... so you create an event to support the Complementary category, and in the process the customer becomes more loyal, spilling money into other categories. 

Your Customer Development efforts thrive when you properly market Complementary categories.

Pickleball Central: Dominant, Complementary, Auxiliary

Those of you in the audience who play a lot of pickleball know all about Pickleball Central.

Obviously, "Paddles" are a Dominant category. It's the primary reason you'd visit Pickleball Central. Some of us churn through a paddle every six months, +/-, some of us collect a hundred paddles and use three of them. Regardless, paddles are the reason you visit the website.

Balls are a Complementary category. If you don't belong to a club, you'll buy balls every few months.

Nets are an Auxiliary category. You don't buy pickleball nets every few months.

Sets & Bundles often serve a dual purpose ... beginners purchase here, meaning that they serve as a Welcome Category in Customer Development terms, and then they are a gateway into other categories.

Shoes are likely to be a Complementary category. So are Accessories.

Clothes are likely a Dominant category - everybody likes to look a certain way on the court, and here in Arizona you'll churn through clothes quickly in 100 degree 9:00am heat.

Gifts likely fall into an Auxiliary category, for obvious reasons.

I don't have the data to analyze Pickleball Central (hint ... hint ... new client opportunity), but those are my guesses.

So as a marketer, you focus on Paddles and Apparel ... your email marketing activities center on those categories. Then you look at the products that are complementary and feature those periodically based on prior purchase preference. Align the products with customer life cycle preferences (i.e. know what a customer with 10 life-to-date purchases buys vs. a first-time buyer) and you have something actionable.

Sometimes It Is Hard To Calculate Margin

Pre-Article Note:  Lots of you are asking what a Hillstrom's Profit project costs ... click here and you'll find out. Interest in projects is currently at a three-year high, so get your project in the queue now before it gets too busy.

Maybe you work at an Agency. The agency sells a product. It costs $1,000,000 to develop the product. You sell the product for $25,000. When you sell the product, it costs you $5,000 to maintain the product per client. You expect to sell the product to 50 clients in year one, 20 clients in year two, 10 clients in year three, and then just 5 clients in year four.

What is the gross margin of this product?

There are a LOT of experts who will give you different answers. Ultimately, you have to do what is right for your business.

In the example above, you expect to sell the product 50+20+10+5 = 85 times. Each time you sell the product you incur a cost of $5,000 ... 85*5,000 = $425,000. You spent $1,000,000 developing the product. Total cost = $1,425,000.

You'll sell 85 "units" ... so $1,425,000/85 = $16,765. Your cost of goods sold = $16,765.

At $25,000 per "unit", your gross margin is $25,000-$16,765 = $8,235.

Your gross margin percentage is $8,235/$25,000 = 32.9%.

I know, there's a LOT of experts who will tell you that my math is wrong.

But conceptually, you now have an idea how profitable your product is.

You can also play "what if" games. What if you sell the product for $40,000 instead of $25,000? Using the "negative square root rule" you might estimate ($40,000/$25,000)^(-0.5) = 79% of the units sold. Maybe you don't believe that and you believe sales would be cut in half. Ok, fine. Now allocate production costs across 42.5 unit instead of 85 units and then tack on the $5,000 cost per unit to maintain the product and see where that takes you.

Again, there are a LOT of experts who will argue with you about the "right" way to do this stuff.

I'm just asking you to "do something".

Dominant, Complimentary, Auxiliary: Impact on Margin

I added summary data to the bottom of the table.

Rebuy Rates:  Dominant Categories possess customers who have a 45.5% chance of buying again from the category. Remaining Categories possess customers who have a 20.4% chance of buying again from the category. That's a big difference.

Other Category Rebuy Rates:  Complementary Categories have customers who have an approximate 69% chance of buying from other categories ... Auxiliary Categories have an approximate 58% chance of buying from other categories. You increase loyalty by showing customers Complementary Categories, all things being equal.

Margin: On average, "Plus" Categories possess a 55% gross margin while "Minus" categories possess a 44% gross margin. Think that's not a big deal? For every $100 you sell in "Minus" categories you generate $11 less profit. As a marketer you can't let that happen. And if somebody demands that you feature those items/categories, ask them what they are going to do about the $11 of profit per $100 they're giving up.

If you think this stuff doesn't matter, well, here, try this one on for size. Say you manage paid search programs at your company. You generate 100 clicks at a cost per click of $0.50. Your conversion rate is 1.2%. Your AOV is $100. Pick/Pack/Ship expenses are 10% of sales. Using these metrics, it's easy to calculate profit.

• 55% Gross Margin = $4.00 Profit.
• 44% Gross Margin = Loss of $9.20.

Do you like generating $4.00 profit, or do you like losing $9.20 and having your Leadership Team criticize you for harming company profit?

Complimentary-Minus and Auxiliary-Minus categories harm company profit. You, as a Marketer, are on the front lines for this fight. Push back when you are asked to promote low-margin categories/items.

Dominant, Complimentary, Auxiliary: Paired with Customer Development

Each of the categories we've analyzed the past few weeks are outlined below, in terms of rebuy rates into the category, rebuy rates into all other products, and this year's gross margin percentage. Tell me what you observe?

The two columns on the right label each category. We have several segments.

Dominant:

• Category 19, Category 12.

Complimentary Plus (Complimentary and High Gross Margin).

• Category 06, Category 01, Category 08, Category 11, Category 21, Category 14.

Complimentary Minus (Complimentary and Low Gross Margin).

• Category 00, Category 03.

Auxiliary Plus (Auxiliary and High Gross Margin).

• Category 10, Category 15, Category 18, Category 16.

Auxiliary Minus (Auxiliary and Low Gross Margin).

• Category 07, Category 20, Category 13, Category 04, Category 02, Category 09, Category 17.

As a marketer, you should be particularly careful about featuring "Auxiliary Minus" items. These items belong to categories where the customer is unlikely to repurchase from the category, less likely to repurchase from the rest of the brand, and if the customer buys from the category the customer generates lower-than-average gross margin dollars. In other words, the marketer who features these products sub-optimizes Customer Development and sub-optimizes profit. 

That's a bad combination.

Dominant, Complimentary, Auxiliary

Much of my recent work is coalescing around a common theme when measuring the interaction between customers and merchandise. Every brand has items/styles/skus ... the items/styles/skus belong to a Merchandise Category ... and customers interact with the Merchandise Category in differing ways ... ways that can be segmented and acted upon.

The segmentation outline?

• Dominant
• Complimentary
• Auxiliary

What is a Dominant Category?

• The category is at the top of your categories for rebuy rates back into the category. In other words, your customers go back to this category after buying from it previously.

What is a Complimentary Category?

• The category is in the bottom 67%-90% of your categories for rebuy rates back into the category ... however, the category is in the top half for repurchase into other categories. In other words your customers might go back to the category, but the customer is likely to maintain a relationship with the brand regardless.

What is an Auxiliary Category?

• The category is in the bottom 67%-90% of your categories for rebuy rates back into the category ... however, the category is in the bottom half for repurchase into other categories. In other words, your customers might go back to the category, but the customer might also move away from the brand.

Chew on the definitions tonight. Tomorrow, we'll explore and expand this relationship.

Your Data Needs To Look Like This

This company has a good relationship between in-category rebuy rates and future gross margin percentage within a category.

Ok, some categories have customers who are very likely to repurchase into that category next year ... for this company, those are rates above 35%. Similarly, other categories possess customers who are unlikely to repurchase into the category in the next year ... their rates are around 15% to 20%.

Here's the positive story told by the graph. Categories possessing customers who are likely to repurchase into the category next year have high gross margin percentages. Categories possessing customers who are unlikely to repurchase into the category next year have lower gross margin percentages.

If your graph has a "negative slope", then your customers are chewing through profit, sub-optimizing the brand.

Not this brand, however. High rebuy categories have high gross margins. Well done!

What does the data look like for your brand?