If there's one metric your eCommerce brand must track besides overall profitability, it's contribution margin (CM). Contribution margin provides valuable insights into the profitability, pricing, and overall success of your product catalog and business as a whole.
What is contribution margin?
Contribution margin is usually used to calculate and track profitability on a unit basis. It is your top-line sales minus discounts, refunds, returns, cost of goods sold, and marketing costs. In short, it is your gross margin minus variable costs.
Your CM is a great number that reflects your company's health and is the main component in calculating your Break-Even Point (BEP).
Is contribution margin the same as net profit?
No, it is not. Your CM calculates the money you have after removing your variable costs, but you still have to factor in your fixed costs to get your net profit or net income. Your CM shows you how much return you get from your products.
How to calculate contribution margin
Before we get into the calculations, let’s touch on two relevant costs: variable costs and fixed costs (if you know what these are, feel free to skip to the formulas below).
Variable costs are a component of the contribution margin formulas, and fixed costs will be relevant later when we talk about leveraging CM.
What are variable costs?
Variable costs are business expenses that fluctuate over a period of time. Examples of variable costs include marketing costs, billable wages, shipping, production costs, and utilities, such as electricity.
These costs all vary based on your production and manufacturing. You may pay the same amount per unit of raw materials used to make a product (unless there are price changes in the raw materials themselves), but the quantity of raw materials may vary based on how much you produce.
What are fixed costs?
These are the costs that stay the same regardless of your business's activities. Some examples include rent, insurance, depreciation, and salaries. Fixed costs remain the same no matter how much product you sell.
Two contribution margin formulas
You can calculate and express CM in two ways: as a dollar amount and as a ratio (or percentage). To calculate CM as a dollar amount, subtract product variable costs from product revenue:
To calculate CM as a ratio (known as contribution margin ratio), subtract product variable costs (including marketing expenses) from gross product revenue, and divide the difference by gross product revenue:
For example, let's say you sell hats for $10, and your variable costs are $5.
- Your formula would be: (10-5)/10=.5, making your CM .5 or a ratio of 50%.
- If you sell 100 of these hats, your gross product revenue is $1,000.
- With a contribution margin ratio of 50%, your CM total is $500.
Why is contribution margin a vital metric?
Contribution margin is vital because it helps you to see what costs you must cut back on and where to increase investment in your brand. For example, by setting goals around what your CM should be, you can manipulate how much you spend for customer acquisition cost (CAC) and optimize your marketing budget.
If you have a negative contribution margin, it means you’re losing money on every sale you make. If you’re CM is negative, alarms should be going off throughout your office, and the team needs to reevaluate your product and marketing costs.
How you benefit from optimizing your contribution margin
Identify changes in variable costs:
For DTC brands, marketing expenses can quickly balloon and cut into profits—this is true even for some of the largest brands. Just look at Blue Apron’s high CAC: for a time, Blue Apron lost money on every new customer due to incredibly high customer acquisition costs. This ultimately caused their stock price to drop significantly due to their unsustainable unit economics.
For marketers, the goal should be to find the best CM for their brand and engineer their marketing efforts around hitting their revenue goals and CM goals. To put it bluntly, marketers that make CM a priority don’t need to worry about metrics like ROAS because they’re already optimized for revenue and profit.
Additionally, by monitoring the profitability of your business as a whole or a product line, you will be able to recognize when profitability is going down and approaching an unsustainable level.
From there, you can make changes to improve your variable expenses or revisit your product costs/pricing. Some examples of changes to make include reducing labor and materials costs, increasing MOQs, optimizing the production process to reduce utility costs, and cutting down on commissions or transaction fees.
Increasing or reducing the prices of your products
By identifying each product's CM, you see how that product contributes to your overall profitability. If the margin is negative or low, you may consider increasing the price to increase its contribution margin, or changing the product's cost structure.
The opposite may also be true:
Ensuring you have enough to pay fixed costs each month
Contribution margin is often used to make sure you can cover your fixed costs: think your team’s salaries, office, and tools. If you have a high contribution margin, you will have more capital to cover fixed costs as you scale your business. By knowing your CM you can manipulate different levers throughout your business to improve it, ensure you’re able to pay the bills, and then some.
How to improve contribution margin
Retain more customers
Customer retention is perhaps the most important and cost-effective growth strategy for eCommerce businesses going into 2022. Having customers consistently purchase from you creates a foundation for your business and grows your revenue more predictably.
By retaining more customers, you are ensuring sales in the future to help meet those cost demands. Creating a loyal customer base also means that if you happen to raise your prices, they will be more likely to stick around despite the increase(s). Additionally, by relying on less expensive retention channels like email and SMS rather than acquisition, your CPOs will be lower, and your contribution margins will be higher.
One of the best ways to improve customer retention is to leverage zero-party data. By collecting valuable data from your customers, you can ensure your retention campaigns are relevant and personalized, which will lead to higher repurchase rates.
Reduce your expenses & shipping costs
Another option is to decrease your variable costs. For example, you could include reducing material costs by finding a different provider that offers lower prices, increasing MOQs to attain lower per unit costs, or changing your shipping and fulfillment provider.
If you can't lower your variable costs, you will have to increase your revenue per sale/AOV. To increase AOV, think through what Upsells/Cross-Sells or Bundles you can introduce, what incentives can you provide like Free Shipping thresholds or Buy Now Pay Later programs tied to higher cart values. As CAC continues to rise and operational expenses increases you will need to think about how to both increase your Product Revenue while saving on variable costs where you can.
Consider increasing prices
The last major option is the simplest, but it’s also the trickiest. Another way to increase contribution margin is to raise your prices to match your variable costs. Raising your prices will increase your gross revenue, but simply raising your prices is a decision that requires some significant thought and planning to be successful.
Some customers who may be less price-sensitive may not mind as much, but higher prices may turn off potential new customers.
Tracking your contribution margin (and everything else) with Daasity
If you don’t know us, hi! Welcome! Daasity is a data and analytics platform purpose-built for consumer brands. We automatically organize and manage all (really, we mean all) your eCommerce, Amazon, retail, and/or wholesale data. We centralize it, update it daily, allow you to run custom reports, and build custom metrics and dashboards.
To learn how Daasity makes it easy to track all your eCommerce performance, metrics, and KPIs, head over here to schedule a demo with our team.
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