We're an online retailer and one of our investors constantly focuses on whether or not our average order value is increasing. I'm more concerned with total revenue growth. Should we do our best to ignore him?
-- Name withheld by request
Let's get this out of the way first: Never ignore your investors. They're your best friends. And they have a right to ask voice concerns and ask questions--their investment purchased that ticket.
Now let's start with the basics. Average order value (AOV) is simple to calculate:
AOV = total sales revenue divided by total number of sales
Say you sell a variety of watches. Last month total sales were $212,000 and you had 108 total orders. $212,000 divided by 108 = $1,962, so your AOV was $1,962.
Keep in mind the same customer could initiate multiple transactions; AOV determines sales per order, not sales per customer.
In general terms, AOV can help you understand whether customers tend to order more expensive or less expensive products, how many products they tend to order, and can also help you understand the relationship of transaction costs to transactions. The higher the AOV the more you spread out your transaction, admin, etc costs. If every order costs you $8 to process, etc, then a $500 AOV means your transaction costs are a lot lower, in total, than if you have a $100 AOV.
Here's an example. Say you determine that it costs you $4.00 to process every transaction. Your AOV is $30 and you make a profit (after expenses, including transaction costs) of $3. You would love to increase your profits, so one way could be to reduce the price on certain items.
I know what you're thinking: "Increase profits by reducing prices? Doesn't make sense." In this case it could.
Cutting prices on certain products could cause purchasers to add those products to their order. If that happens, you make more money on that sale because your transaction costs are spread over a larger AOV. In this case, cutting a price by 10 percent could result in additional sales per order and actually increase your total profits. While your gross profit margin on that item will fall, total profits may increase. Remember, profit equals sales minus total costs; what's important is not the price you sell a product for but the portion of that sale you get to keep.
Since yours is an online business, AOV is also useful as a quick way to think about changes to conversion rates and site visitors. Say you currently convert 5 percent of your site visitors and your AOV is $75. If you attract 1,000 more qualified customers to your site and your conversion rate stays the same, you'll generate $3,750 more in sales. (What would you be willing to pay to get $3,750 more in sales?) Or, if you increase your conversion rate by 20 to 6 percent and your AOV stays the same, you'll generate $1,500 more in sales.
So back to your question: Is your investor right to focus on AOV?
As with many things, it depends.
If your lifetime customer value is high, because once you land a customer they tend to keep coming back for more, then pricing and/or shipping strategies designed to make it tempting for new customers to make relatively small purchases could make sense. If, once you land them, you tend to keep them, then a lower AOV could be a harbinger of great things in the future.
On the other hand, if you hope to boost AOV by utilizing Amazon's "other customers also purchased" strategy, then changes to AOV will signal the success or failure of those efforts.
So what would I do? I would ask a few questions, if only because it's a great chance to build a better relationship with that investor. Ask what he's looking for. Ask what he hopes to see. Ask what strategies he feels will be effective in increasing or decreasing your AOV. I'm sure there's a reason he focuses on AOV. So ask.
You might learn something that helps your business grow.
Check out these financial and performance measurement articles:
- 4 Business Metrics You Can't Afford to Ignore
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- The Best Way to Track Customer Retention Rate
- A Bootstrapper's Guide to Working Capital
- Most Important Clicks to Track on Your Website
- Should You Track Economic Value Added?
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