eCom Fundamentals - Contribution Margin

Introduction

As an ecommerce business, understanding your contribution margin is crucial for making informed decisions about your operations. At a high level, contribution margin is the amount of revenue remaining after all variable costs have been subtracted, and it is a key metric for determining the profitability of your product lines and pricing strategies. In this blog post, we will define contribution margin and explain the main components that go into its calculation. We will also discuss the importance of understanding contribution margin and provide examples of how you can optimize your operations to improve.?

Contribution Margin: Defined

Contribution Margin can be calculated using the following formula:

(Product Revenue - Variable Costs) ÷ Product Revenue

The output of this equation is a fraction, typically expressed as a percentage. By subtracting variable costs from revenue, you are left with the amount of money available to cover fixed costs and generate a profit. Therefore,?the higher the contribution margin, the better.

For example, if you had a product line with $100k in revenue generated, and $15,000 in total variable expenses, you would have a contribution margin of 85%.

($100,000 - $15,000) ÷?$100,000 = 0.85 = 85%

Note:?Sometimes when using a percentage, this is called the?Contribution Margin Ratio.?This can be especially useful to quickly compare the profitability of various product lines or pricing strategies.

Product Revenue (Money In)

Quite simply, the Product Revenue is all of the revenue generated from sales. However, it’s important to note that this should be?actual dollars received?- it’s a common mistake for merchants to use the list price of a product when calculating contribution margin, while not taking into account any discounts that were applied. It’s incredibly important to take into account discounts or price lists when calculating contribution margin, so that you have an accurate understanding of your profitability.

Variable Costs (Money Out)

Variable Costs are business expenses that change based on the level of production or sales. This is in contrast to fixed costs, like rent, which is the same no matter how many units you produce or sell.

For most eCommerce businesses, the most important variable costs are:

1. Cost of goods sold (COGS):?This includes the costs of the products or goods that are sold, such as the cost of materials, labor, and manufacturing. It's one of the most important variable costs for an ecommerce business, as it directly affects the profitability of each product or product line. Note that?Landed Costs?should also be included in the COGS calculation, which are the additional costs that are incurred when the product is imported, such as duties, tariffs, freight, and insurance.
2. Fulfillment and logistics costs:?These include the costs associated with storing, packaging, and shipping products to customers. For an ecommerce merchant, these costs can vary depending on the number of orders, size and complexity of the product, number of countries shipped to, customization, and many other factors.?
3. Marketing and advertising expenses:?These include costs associated with promoting products and driving sales, such as pay-per-click advertising, affiliate marketing, and email marketing. These costs can vary depending on the marketing strategy and the level of spending.
4. Payment processing fees:?These are the costs associated with accepting and processing payments, such as credit card processing fees, gateway fees, and fraud prevention costs.
5. Return and refund costs:?These include the costs associated with handling returned or refunded products, such as restocking and repackaging expenses.

Why It Matters

Contribution Margin can be a defining metric for your eCommerce business that can help you make decisions across almost every area of your business. This includes?Product Development, from design, material selection, and pricing, through to marketing, and even logistics strategy, where you can identify the most effective way to get the products into the hands of your customers. You can (and should) be calculating Contribution Margin across your various channels and products, to have a more granular understanding of your profitability.?

For example - if you’ve recently expanded into a wholesale channel, it’s very important to understand the Contribution Margin of wholesale compared to D2C and/or retail, so that you can ensure you are still scaling profitability, despite the increased sales volume.

Benchmarks - What should you aim for?

In general, the higher the contribution margin the better, as this typically means that you have overall higher profitability. It’s helpful to look at the public market to see what large eCommerce merchants are reporting, and use this as a benchmark.

However, Contribution Margin is typically not specifically stated in earnings reports; it is not required by the SEC, and instead, many companies use Gross Margin as the standard financial metric (Revenue - COGS). This is also in line with Generally Accepted Accounting Principles (GAAP), while the calculation of Contribution Margin might not be as standard.

That said, while Gross Profit Margin and Contribution Margin are definitely not interchangeable, it can be helpful to look at publicly available Gross Margin data to see where your company lines up.

Gross Profit Margins

• Casper = 51% [1]
• FIGS = 72% [2]?
• Allbirds = -28% [3]
• Warby Parker = 58% [4]

How to improve Contribution Margin

A fundamental prerequisite to improving Contribution Margin is analyzing the?quality of the data?going into the calculation. As the old saying goes, garbage in = garbage out, and without accurate data, you cannot rely on the outputs of your Contribution Margin calculations.

One of the most common ways that merchants end up with low quality data being used in their Contribution Margin calculations, is not having a system with enforceable controls around data entry and validation. If the entire business is being run out of spreadsheets, it can be easy to make a mistake or overwrite critical data when doing something as basic as Purchase Orders, for example.

However, in contrast, using a more comprehensive system like an ERP, can provide your team with the structure to be able to enforce quality data entry.?

As an example,?Fulfil ?was built from the ground up with the common workflows every eCommerce merchant needs - generating purchase orders, partially receiving supplier shipments, tracking landed costs and more are all out-of-the-box functionality that will have a direct impact on the accuracy of your Contribution Margin calculations.

Outside of a software solution, there are many other operational ways that you can improve your Contribution Margin. Here are several areas you should consider

Shipping Costs

Optimize Carrier Selection

• Ensure that you are using a Rate Shopping solution to find the cheapest possible shipping option
• Consider setting up specific zones for more local delivery - if a customer has selected 2 day expedited shipping at checkout, but they live relatively close to your fulfilment center, there’s a chance that standard ground shipping will still satisfy the fulfilment requirements. Therefore, paying for the expedited shipping is not required, and this can be solved through the usage of shipping zones and automation rules.

Fulfillment Costs

Optimize Packaging Materials

• Consider offering a ‘sustainable’ packaging option at checkout, which uses reduced and simplified packaging. This can be a win-win: your customer will feel great about reducing waste and helping the environment, and you will have the benefit of an improved Contribution Margin.

Optimize Cartonization

• Reduce packaging and shipping costs by using the most efficient carton size and reducing the number of cartons used.
• This will in turn reduce the amount of packaging materials used, which will lower the costs of goods sold.

Combining Orders

• If a customer places multiple orders within a short period of time, and prior to the fulfilment process starting, it makes sense to combine these orders into a single shipment to save on shipping costs.?
• With?Fulfil , this can be done with a single click on the automatically generated banner prompt within the WMS.

Fulfillment Errors

Scan to Pick/Pack

• Using a handheld (or fixed) scanner at the Pick and Pack stages of your fulfillment center can drastically reduce the number of errors in your shipping process, which has a direct impact on Contribution Margin.

Product Structure

Increase AOV?

• If the Average Order Value (AOV) increases, even while the number of orders stay the same, you will likely see an improved Contribution Margin due only marginally increased fulfillment costs being distributed over more revenue.?
• Consider upselling, cross-selling, and bundling products to drive up AOV.

At a high level, the only way to improve Contribution Margin is to either increase the Money In, decrease the Money Out, or both.

Conclusion

In conclusion, contribution margin is a key metric for ecommerce businesses to understand and use as a guide for making data-driven decisions. It represents the amount of revenue remaining after all variable costs have been subtracted and can be used to optimize pricing, product selection, marketing, and logistics strategy, among other things. To learn more about how Fulfil can help you improve your Contribution Margin,?book a demo ?with our team.

References

[1] https://www.statista.com/statistics/1119512/casper-gross-margin-worldwide/

[2] https://www.macrotrends.net/stocks/charts/FIGS/figs/-margins

[3] https://www.macrotrends.net/stocks/charts/BIRD/allbirds/profitgross-margin

[4] https://investors.warbyparker.com/financials/quarterly-results/default.aspx