Demystifying Contribution Margin for Online Sellers

May 16 Written By Peter Marler

As an ecommerce business owner, understanding your company's financial health is crucial for making informed decisions and driving growth. One key metric that can provide valuable insights into your business's profitability is contribution margin. In this article, we'll dive deep into the concept of contribution margin, its calculation, and how it can help you optimize your online selling strategy.

What is Contribution Margin?

Contribution margin is the amount of money left from sales revenue after subtracting the variable costs associated with producing and selling a product. It represents the portion of sales that contributes to covering fixed costs and generating profit. Contribution margin can be calculated on a per-unit basis for a specific product or for an entire product line.

Why Contribution Margin Matters for Online Sellers

Contribution margin plays a vital role in pricing decisions, as it helps you determine the minimum price at which you can sell a product without incurring a loss. By understanding your contribution margin, you can make informed decisions about which products to prioritize, how to allocate resources, and where to focus your marketing efforts. Ultimately, a higher contribution margin leads to increased profitability for your ecommerce business.

Calculating Contribution Margin To calculate contribution margin, you'll need to know your sales revenue and variable costs for a specific product or product line. Follow these steps:

1. Determine your sales revenue by multiplying the selling price by the number of units sold.
2. Identify your variable costs, such as product costs, shipping expenses, and marketing costs.
3. Subtract the variable costs from the sales revenue to obtain your contribution margin.

Contribution Margin = (Revenue - Variable Costs) / Revenue

= ($100.00 - $60.00) / $100.00

= $40.00 / $100.00

Contribution Margin = 0.40 or 40%

Factors Affecting Contribution Margin in Ecommerce

Several factors can impact your contribution margin in the world of ecommerce:

• Variable costs: Product costs, shipping expenses, and marketing costs directly affect your contribution margin. Lowering these costs can lead to a higher contribution margin.
• Sales revenue and selling price: Increasing your selling price or generating more sales can improve your contribution margin, as long as the additional revenue outweighs any increase in variable costs.
• Platform fees and commissions: Ecommerce platforms often charge fees or commissions, which can eat into your contribution margin. Be sure to factor these costs into your calculations.

Let's look at another example of a contribution margin calculation using some of these common e-commerce variable costs in a single unit.

Let's say your company is Super Duper Apparel.    Your best selling item is your Super Duper Polo.  The retail price for that unit is $80.   Here is what that calculation would look like:

Strategies to Improve Contribution Margin

To boost your contribution margin and overall profitability, consider implementing these strategies:

1. Optimize product pricing: This may seem obvious, but this is the #1 thing that you can do as an ecommerce business to improve your contribution margin.  Increasing prices can seem scary because it may result in a decrease in sales.  But assuming improve your profitability is the goal, even if sales go down you can still easily achieve an increase in contribution margin and unlock longer runway for your business.

Consider this basic example:

You own the company "Luxury Watches Inc." that sells high-end watches. Initially, you sell their watches for $1,000 each and have the following financial data:

Now let's imagine that you increase prices by 10%.  Because of this, your sales decrease by 15%.  Let's see how this impacts contribution margin:

You see - despite increasing prices 10% resulting in a 15% decrease in sales, you still experience a 5pp increase in contribution margin.  Pretty crazy right?

2. Reduce variable costs: Negotiate better terms with suppliers, streamline your shipping processes, and optimize your marketing spend to minimize variable costs.  Marketing costs, or customer acquisition costs (aka CAC) are a major component of variable cost as an online seller.  Consider ways to diversify your marketing spend so that you aren't overexposed on a single channel

When Apple made its iOS 14 update in September 2020 it introduced significant changes to user privacy and data tracking.  This change greatly affected the digital advertising landscape, particularly for direct-to-consumer (DTC) businesses relying on platforms like Facebook and Google.  As a result, CACs skyrocket for these  brands, forcing many to reduce costs or close altogether.  

3. Implement effective inventory management: Avoid tying up capital in slow-moving inventory and focus on products with higher contribution margins.  Effective inventory management is an incredibly difficult problem. Don't do it alone.  There are many technologies that exist that support automated and intelligent inventory management.  Consider platforms like CIn7, Extensiv, and Luminous.  If you find inventory planning/demand forecasting a bigger problem, look into platforms like Cogsy or Inventoro.  

Analyzing Contribution Margin at the Product Level

To make data-driven decisions, it's essential to analyze contribution margin at the product level. By identifying high and low contributing products, you can optimize your product mix, allocate resources more effectively, and focus on items that generate the most profit for your business.

Contribution Margin and Your Income Statement

Contribution margin directly impacts your income statement, as it represents the amount of money available to cover fixed costs and contribute to net income. By improving your contribution margin, you can increase your overall profitability and boost your bottom line.

What is a Good Contribution Margin?

A "good" contribution margin varies by industry and business model. However, as a general rule of thumb, a contribution margin ratio of 40% or higher is considered ideal.

To set appropriate contribution margin goals for your ecommerce business, research industry benchmarks and consider your specific costs and competitive landscape.

Tools for Calculating Contribution Margin To streamline your contribution margin analysis, consider using:

1. Spreadsheets and templates
2. Ecommerce accounting software
3. Specialized contribution margin calculators

Common Mistakes to Avoid

When incorporating contribution margin analysis into your ecommerce strategy, be sure to avoid these common pitfalls:

1. Overlooking the significance of contribution margin
2. Failing to regularly monitor and adjust your contribution margin
3. Neglecting the impact of variable costs on profitability

Frequently Asked Questions about Contribution Margin

1.  How often should I review my contribution margin?

It's a good practice to review your contribution margin regularly, such as monthly or quarterly, depending on your business's sales cycle and financial reporting cadence. Reviewing contribution margin frequently allows you to:

• Monitor the profitability of individual products or services
• Identify trends or changes in your cost structure
• Make timely decisions about pricing, production, or marketing strategies
• Assess the impact of any changes in your business environment

2. Can I have a negative contribution margin?

Yes, it's possible to have a negative contribution margin. This occurs when the variable costs associated with a product or service exceed the revenue generated from its sale. A negative contribution margin indicates that each unit sold is not contributing to covering fixed costs or generating profit, and instead, it's causing a loss.

3.  How does contribution margin differ from gross margin?

They’re similar!  But here is the main difference

Contribution Margin: This measures the percentage of revenue that remains after subtracting the variable costs (COGS, shipping, labor, marketing etc)  associated with producing and selling a product or service. It represents the amount available to cover fixed costs and contribute to profit.

Contribution Margin = (Revenue - Variable Costs) / Revenue

Gross Margin: This measures the percentage of revenue that remains after subtracting the cost of goods sold (COGS), which includes the direct costs associated with producing a product or service, such as materials and direct labor.

Gross Margin = (Revenue - Cost of Goods Sold) / Revenue

Actionable Steps for Implementing Contribution Margin Analysis

To get started with contribution margin analysis, follow these steps:

1. Identify your variable costs for each product or product line
2. Calculate your contribution margin and contribution margin ratio
3. Analyze your results and identify areas for improvement
4. Implement strategies to optimize your contribution margin
5. Regularly monitor and adjust your contribution margin

Additional Resources

To further your understanding of contribution margin and its application in ecommerce, check out these recommended resources:

• "Contribution Margin: What It Is and How to Calculate It" by Shopify
• "Ecommerce Finance - The Ultimate Guide to Making More Money" by Mayple
• "Contribution Margin for E-commerce Businesses Explained" by Around Finance

Conclusion

Contribution margin is a powerful metric that can help you make informed decisions, optimize your product mix, and ultimately improve your ecommerce business's profitability. By understanding how to calculate and analyze contribution margin, you can gain a competitive edge and drive long-term success in the dynamic world of online selling.

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