How to define marketplaces’ profitability and identify its main drivers?
Online marketplaces are basically platforms that aim to frictionlessly connect buyers and sellers (or at least multiple counterparts). However, given their tremendous growth over the past decade, their profitability is less easy to assess, and margins need to be determined on several levels.
As with most emerging digital companies, EBITDA does appear at first glance to be the most relevant aggregate to analyse profitability, particularly for fast growing companies. In this article, we will focus on made on “Gross and Direct margins”, i.e. revenue minus what can be considered as costs directly contributing to the performance of the core activity (gross margin includes the more variable costs, and direct margin the other direct costs). Since marketplaces can also take many different forms, we will present the basic and broader case of a commission-based B2B or B2C model (as a reminder, though marketplaces contribute to the expansion of e-commerce, we distinguish them from pure e-commerce enterprises, the latter notably deriving their profitability from “margins” rather than “commissions”). The framework presented here-below is a proposed analysis grid, and will be adapted to each business model and marketplace company.
Gross Merchandise Value (or Gross Merchandise Volume (GMV)) is the most “top-line-positioned” indicator. It is basically determined as the volume of products (or unit of services) sold through the platform multiplied by the corresponding unit selling prices (or orders multiplied by the average selling orders prices). Though GMV in itself gives a relatively limited indication of the profitability pattern of a marketplace, the analysis of its growth drivers can provide useful information regarding the evolution of margins, not only in terms of values, but also rates.
GMV evolution can be broken down into 3 effects:
- Volume of products,
- Prices per product,
- Mix of products.
The control of these drivers is more-or-less shared with suppliers (providers) and also relies on market dynamics and characteristics. All these parameters of effects impact margins, but only the price and mix have an influence on margin rates (volume can have an indirect impact through discounts and price reductions). Note that a relatively similar (and simpler) analysis can be made using the volume of orders and average selling prices per order.
The “real” Revenue of the marketplace comes from commissions applied to the monetary volume of transactions (GMV) (however, it should be noted that marketplaces can generate other types of revenues, such as subscriptions from premium accounts, advertising, monetisation of data…).
The “take rate” (aka “Rake”) is calculated as the ratio between revenue and GMV (a sort of commission rate). This rate can vary greatly from one “sector” to another, and over time. Its main drivers (both in terms of level and evolution) can be summarised as follows (some of them may be interrelated):
- Value proposition: the more services and risk the platform provides/bears, the higher the commission rate can be;
- Competition comes not only from other platforms but also from alternative distribution channels for suppliers;
- Network effect: the more the platform is used by buyers and/or sellers, the more essential it becomes to its participants;
- Suppliers’ profit margins and price sensitivity.
Now that we have a clearer understanding of the structure of revenue, an essential contributor to profitability, let’s take a deeper look at margins.
There is no standard approach to the breakdown of margin aggregates, mainly due to the diverse nature of business models. Very often, we observe that two to three sub-aggregates may prove to be relevant (denominations such as “Contribution margin 1”, “Contribution margin 2”, “Contribution margin 3” are widespread). Yet, a useful and simple approach is to distinguish between (i) “direct variable costs” related to transactions and (ii) “acquisition costs of clients”. Let’s call the former “Gross Margin” and the aggregate stemming from the latter “Direct Margin”.
In the following definition, the Gross margin indicator bears some resemblance to the one often used in SaaS analytics, albeit with different weighting. Contrary to e-commerce companies, costs of goods sold do not correspond to the costs related to merchandise (implicitly embedded in the GMV in this case). Rather, COGS may encompass (i) direct IT & hosting costs (servers, network bandwidth, power etc.), (ii) customer success and (iii) payment gateways (the latter being less common in subscription-based SaaS models).
The increase in Gross margin rate is thus mainly related to (i) the improvement of the “take rate”, (ii) the evolution and better absorption of direct IT costs, (iii) productivity gains in terms of customer success and (iv) lower payment charges per transaction.
In some cases, all the more so when intermediation can be considered as “managed”, additional categories of direct personnel costs, which are more related to the realisation of the core services delivered by the platform, will require the introduction of another level of contribution margin (denominations such as “Contribution Margin 1” (CM1) or “Contribution Margin 2” (CM2) – in the latter case when GM refers to CM1 – can be used).
In recurring subscription-based models, client acquisition costs are excluded from gross margin (or direct margin) as such costs usually don’t usually recur over time once the company has the clients (without neglecting the possible existence of renewal costs). In marketplace models, transactions rather than subscriptions tend to drive revenues. The costs of acquiring clients (whether they are buyers and/or sellers) are then more related to revenue, and therefore more “variable”. Since the relation between revenue and acquisition costs is not as direct as the one stemming from COGS (or direct personnel), the corresponding costs are presented in a different aggregate of direct margin (or Contribution margin 1 or 2 or 3, depending on the previous denominations).
Direct costs added to direct margin consist of sales and marketing expenses, at least those considered to be “direct” (Google Ads, sales employees’ wages etc.). The classification of sales and marketing expenses as direct costs is not so obvious, and part of them can be considered as indirect costs (all the more so because management/investors would want to present more favourable figures). Consequently and in summary, the level and evolution of marketplace direct margins (or contribution margins) are accounted for by (i) the take rate, (ii) gross margin – cost of sales – drivers (direct IT-related costs, customer success, payment) and (iii) CAC efficiency.
