For the penultimate 12 days of Christmas challenge we’re returning to the profit and loss statement to calculate your contribution margins.
Contribution margins are the incremental amounts generated across all products sold after deducting variable costs.
Contribution margin is an important metric which allows a business to see how sales are contributing to overheads. Breaking contribution down by its various levels and constituent parts helps you make decisions around pricing, sourcing and how much you can spend on customer acquisition.
Contribution margin can help you answers questions like:
Does your best-selling product make any margin –are you sacrificing margin for revenue?
Does selling domestically make a better margin then selling outside the UK?
Do any products give a negative contribution to your business?
Contribution margin is expressed as a percentage and determined at different levels. Each of these different contribution margins reveals something about different variable cost drivers.
In a business, such as an e-commerce business, with three variable cost drivers, the contribution margin levels can be defined as:
Contribution margin 1 (CM1): Sales less cost of goods sold e.g. the product cost or materials and direct labour to develop the product. This is traditionally known as gross profit.
Contribution margin 2 (CM2): CM1 less all the directly attributable costs of generating sales e.g. logistics, warehousing, fulfillment and payment gateway fees.
Contribution margin 3 (CM3): CM2 less digital and offline marketing costs.
By considering your contribution margin at these three levels, you will also understand where you lose contribution. For example, if your CM1 is strong but your CM2 is low it enables you to focus on your variable cost drivers at this level e.g. review your logistics partners, re-negotiate payment processing fees, all of which will reduce costs and improve your contribution.
A common mistake would be assuming that you should cut your lowest-contribution-margin products. While it may seem the right strategy, it isn’t necessarily the case. You should never exclusively use one measure to make this type of decision. You must consider your wider portfolio of products and how this will impact customers.
What does contribution look like?
How do you calculate contribution margin?
The formula to calculate contribution margin is:
Contribution margin 1 = Sales – Cost of goods sold
Contribution margin 2 = Contribution margin 1 –Logistics and similar variable costs
Contribution margin 3 = Contribution margin 2 – Sales & Marketing costs