Contribution margin – an introduction
Contribution margin is the incremental amount generated in aggregate across all products or units sold after deducting variable costs. Contribution margin can be assessed at a business level or at a unit level.
Unit economics also refers to a company’s revenues and variable costs but related to an individual unit. A unit is simply one separate, quantifiable element that the company creates and sells e.g. a product or order.
What is contribution margin?
For an e-commerce business, contribution margin is determined at different levels. These are often referred to as:
- contribution margin 1 (CM1)
- contribution margin 2 (CM2) and
- contribution margin 3 (CM3).
Each of these different contribution margins reveals something about different variable cost drivers.
Contribution margin is often expressed as a percentage. The long-term aim is to achieve a positive contribution margin to support fixed overheads and generate a profit. Fast-growth e-commerce businesses often operate at very low or even negative contribution margins in order to acquire customers and build market share fast.
The three contribution margin levels can be defined as:
- 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.
- CM2: CM1 less all the directly attributable costs of generating sales e.g.logistics, warehousing and payment gateway fees.
- CM3: CM2 less digital and offline marketing costs.
Why is contribution margin important?
Contribution margin is an important metric which allows a business to see how sales are contributing to overheads and EBITDA.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. However, like all metrics it shouldn’t be used in isolation as it only tells part of a story. It’s possible to have a low CM3 but coupled with a high repeat order rate, it can still be an effective strategy, albeit it will hit working capital in the short-term.
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?
Without tracking and understanding your contribution margin it's impossible to determine how you will generate a profit as you scale, and how quickly you can afford to scale.
By considering your contribution margin at CM1,CM2 and CM3 levels, you will also understand where you lose contribution. For example, if your CM1 is strong but your CM2 is low it empowers 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.
To understand some of the common pitfalls when looking at unit economics, check out the following article.
What is a good contribution margin?
Generally, the higher your contribution margin is the better. However, contribution margin should be viewed in conjunction with overheads and your growth rate. A high contribution margin could mean you’re not investing enough in growth, and a low contribution margin could mean you’re burning too much cash.
At a CM3 level, you need to be positive, as otherwise you are not contributing profit to fixed overheads. There is no hard and fast rule on what a good contribution margin percentage as it will be dependent on may factors. An example of this would be the level of fixed costs that need to be covered to generate a profit. A business with very low fixed costs requires less contribution margin to turn a profit.
The stage in the company life cycle will also have an impact. If you’re targeting growth and market share, you may sacrifice contribution margin for customer acquisition.
What does contribution look like?
How do you calculate contribution margin?
The formula to calculate contribution margin:
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
Each of the above can also be expressed as a % of sales.
Contribution margin worked example
If a company has the following, it’s contribution margin can be calculated as follows:
- Units sold: 3,000
- Revenue per unit: £55
- Cost of goods sold per unit: £27
- Delivery costs for period: £24,000
- Marketing cost for period: £36,000
Contribution margin 1 = (3,000 units x £55 per unit) – (3,000 units x £27 per unit) = £165,000 - £81,000 = £84,000 or 51%
Contribution margin 2 = £84,000 - £24,000 =£60,000 or 36%
Contribution margin 3 = £60,000 - £36,000= £24,000 or 15%
Contribution margin is an important metric for an e-commerce business to track. Measuring and monitoring your contribution margin helps to better understand the various drivers that influence your overall contribution (and unit economics) to help you scale. Segmenting contribution margin by different geographies or products can provide further insight to help you make even more informed strategic and tactical decisions.