When looking at KPIs, many people focus on metrics like cost of goods or CPA, and overlook contribution margin. But understanding your contribution margin is essential as it provides insights into product and sales channel profitability and helps you to make informed data-driven business decisions.
What is Contribution Margin?
The contribution margin is the amount left from sales after covering variable costs, such as selling and delivering your product to a customer. The resulting contribution dollars can be used to cover fixed costs like rent, with any remaining amount considered profit. Variable costs are expenses that fluctuate depending on your sales or production levels. These costs could include things like the cost of goods sold (COGS), shipping costs, and marketing costs.
This metric can be calculated in both percentage and dollar form. I always recommend calculating both because by just doing one, you may miss out on some key information. Percentages hide things, so being able to see the contribution margin in both forms gives you more context. Also ensure you calculate the contribution margin for different sales channels, as it can change from channel to channel, even for the same product
You should first figure out your margins before you launch your product. If a proposed product has a low contribution margin (or a negative contribution margin), you could rethink your pricing strategy. If it’s not practical to change aspects of the pricing strategy, you might need to consider whether it’s worth launching the product in the first place.
Once a product has been launched, you should still continue to regularly monitor your contribution margin as variable costs like CPA can vary drastically from day to day, meaning your contribution margin will also vary from day to day.
It’s important to note that not all products are destined to have good margins. Some products are loss leaders, used in conjunction with the main product or to lead customers towards higher-margin options. Understanding the specific roles of your products is key.
Why is Contribution Margin Important?
The insights you get from calculating your contribution margin is invaluable for making important informed decisions for your business, especially regarding pricing strategies. Knowing your contribution margin on different channels helps determine if your pricing is sustainable, ensures you cover production, delivery, and marketing costs, and still leave room for profit.
Regular monitoring of product contribution margin allows you to optimise your unit economics in order to continuously improve your performance and scale your business. By focusing on contribution margin, you can identify which products to focus on promoting, which cost structures to adjust, and where you could negotiate better terms, ultimately driving better financial health and growth for your business.
How do you calculate contribution margin?
There are 2 simple ways to calculate your contribution margin:
Or
In the image below, I outline a cost breakdown based on a $99 hoodie. In this example, I used the first contribution margin method to work out the hoodie’s contribution margin. Here you can see I added together the variable costs and subtracted them from the sales cost of the hoodie, leaving me with a contribution margin of $30.82 which is 31.13%.
How is contribution margin different to gross margin?
Understanding the difference between contribution margin and gross margin is essential for effective financial analysis and decision-making within your business.
Gross margin is calculated by subtracting the cost of goods sold (COGS) from total revenue. It provides a broad measure of profitability, showing how much revenue is left after covering the direct costs associated with producing goods. This metric would usually be used to assess the overall financial health of your business, giving insight into how efficiently your company is managing its production costs relative to its sales.
On the other hand, the contribution margin subtracts all variable costs from revenue, not just the COGS. Therefore, contribution margin offers a more nuanced view by focusing on how much revenue is available to cover fixed costs and generate profit after accounting for variable expenses.
What is a good contribution margin?
A rough rule of thumb here (depending on the type of product) is that you want to aim for a minimum of 4x of your COGS. Although, if you sell a low cost product i.e. less than £20 you’ll probably need this multiple to be quite a bit higher. Ultimately, the higher your contribution margin, the better, as it means you’ll have more margin to work with to scale your business and increase your net profit percentage.
However, ideal contribution margin percentages will vary from industry to industry. Wayflyer partnered with Iris Finance to create a P&L report covering the financials of brands within 9 D2C industries for Q1 2024. This report included contribution margin, giving you a bit of a guide to what you should expect yours to be around. Here’s what they found:
If you found after looking at this data that you are under these average CM figures then you might want to have a look to see if you can improve your ratio.
If you find that after calculating your contribution margin, your figures are under the average for your industry, you may want to look at ways to improve your contribution margin.
How to increase your contribution margin
When looking to improve your contribution margin, you have three main options. You can either increase your revenue, reduce your costs, or improve your product offers.
Increase your revenue
One of the main ways to increase your revenue is to increase the sales price of your products. However, in a competitive market, this comes with the risk of pricing yourselves out of the market, reducing your number of customers, ultimately reducing your revenue rather than increasing it.
You could offer incentives to increase your number of customers. But these discounts could affect your contribution margin itself. If this was a route you wanted to go down, you could just offer incentives to your high-value customers or offer added value rather than discounts.
Reduce your costs
In my opinion, the best way to improve your contribution margin is by negotiating better terms with your suppliers, without compromising on quality. This could be negotiating more for your money or reducing costs of raw materials, manufacturing, or freight.
You could start by contacting potential suppliers and asking each of them for a quote based on specific order quantities. This should provide you with volume metrics, help you to understand their pricing scale, and let you know at what cost the product can be obtained (aka the cost of goods).
Within these negotiations, avoid immediately stating the price you want, inquire about their pricing options. Ask them what’s possible and if there are ways to get better rates. Express your interest in a potential partnership without revealing your price expectations.
Another option is to optimise your operations, ensuring you’re not paying any unnecessary variable costs. This could include implementing automated systems to reduce labour costs and speed up operation times. A good rule of thumb here is that your business’s OPEX shouldn’t exceed 15% of total revenue, although this is harder for sub-1m brands. Equally, your shipping and fulfilment costs shouldn’t exceed 10% of your sale price.
Merchandising
Finally, you could improve your contribution margin by providing your customers with better offers in relation to contribution margin. Work out your finances for the different offers you could run and see which is going to provide you with the best contribution margin.
Using our hoodie example, I worked out the finances for 3 offers (25% off, 50% off, 3 for 2) alongside the hoodie with no offer to see which would provide the best contribution margin. Below you can see the offer with the best contribution margin percentage is 25% off. However, this is only 1% higher than the 3 for 2 offer, which has a higher average order value (AOV) and around 3x the contribution margin dollars. Therefore, I would recommend using the 3 for 2 offer to get one of the best contribution margins and a high AOV. Although you would need to monitor the return rates and LTVs of each offer to see how they’re affected too.
Have any questions or want to talk to a specialist about your contribution margin? Just drop me a message.