The eCommerce founder’s guide to calculating contribution margin
When you run a small-to-medium-sized business (SMB), every key performance indicator (KPI) counts. Knowing your eCommerce SMB’s KPIs helps you determine your financial health.
Contribution margin is one of those key KPIs.
Calculating contribution margin lets you know how much profit you make off each product or service you sell. And it can help you determine which products or services to keep, discard, upsell or downsell.
Below, we’ll go into more details about what contribution margin is and how to calculate it.
Note: Keep in mind that contribution margin doesn’t fall under the US Generally Accepted Accounting Principles (GAAP). If you do a lot of business in the US, avoid contribution margin in financial reporting. It’s most useful when analysing your products and/or services, pricing and productivity.
Contribution margin definition: What is contribution margin?
So, what does contribution margin mean?
Contribution margin is a measure of how much revenue a certain item is making (or costing) your business. Put simply, it’s the amount left after you subtract variable costs from total revenue.
You can calculate contribution margin per unit (i.e. product or service) or overall (i.e. your total cost of production).
Increasing your overall contribution margin can help you reach your break-even point — a crucial measure of your SMB’s health. Contribution margin per unit is especially important for SMBs because each product or service counts towards your total revenue.
Plus, knowing your contribution margin gives you an excellent way of determining how or whether you should adjust product prices. The more you know about your products, the better you can assess your customer lifetime value.
It’s a fairly simple concept, but you’ll need to know what your variable and fixed costs are beforehand. And that process can be a bit more complicated than it first seems.
We’ll expand on fixed vs variable costs later — determining what expenses fall into which category can be tricky.
Contribution margin formula, CM ratio formula and other KPI formulas
Although the core contribution margin formula is simple, other calculations may help your SMB fine-tune its offerings, prices and products. Alongside contribution margin, here are other helpful KPI formulas. Keep in mind that for each formula, the time period measured should be the same (e.g. quarterly, annually).
First, here’s how to find the contribution margin in the most basic sense (a dollar amount):
Total revenue − Variable costs = Contribution margin
After learning how to calculate contribution margin, many SMBs find it useful to know the contribution margin per unit value. Here’s the contribution margin per unit formula:
(Total revenue − Variable costs) ➗ Total units = Contribution margin per unit
Next, let’s look at how to calculate contribution to profit using the contribution margin per unit value. Here’s the formula:
Contribution margin per unit ✖ Number of units sold = Contribution to profit
Next, you can find your contribution margin (CM) ratio. What is a contribution margin ratio? Essentially, it’s your contribution margin as a percentage.
Here’s how to find the CM ratio (a percentage):
(Total revenue − Variable costs) ➗ Revenue = CM ratio
However, it makes sense to find your gross profit margin as well. You should know the cost of goods sold (COGS):
Total revenue − COGS = Gross profit margin
Contribution margin and gross profit margin differ, but they are related. We’ll get into that relationship in greater depth shortly.
Knowing a product’s contribution margin as a dollar amount and as a percentage can give you separate insights. For instance, the dollar amount may help you adjust prices, but the percentage may help you plan overall pricing strategies.
[Related: How to calculate opportunity cost]
Fixed costs vs variable costs
On the surface, the difference between fixed costs and variable costs is simple. Fixed costs are costs that remain the same regardless of sales and production. Variable costs change according to sales and production and fall under COGS.
For instance, let’s say your eCommerce SMB sells woven baskets. You may rent a warehouse monthly or yearly. That rent is a fixed cost because you must pay it to keep production stable.
However, variable costs shift, often per time period. For instance, the raw materials you use to make woven baskets, such as rope and paint, may change per season. If holidays (e.g. Easter, Halloween) increase your sales volume, then your variable costs for those raw materials increase alongside demand and production.
When you know your contribution margin, you can adjust variable costs to cover fixed costs. In fact, that’s one of the most important insights an SMB can gain from knowing its contribution margin.
Contribution margin vs gross profit margin
Both contribution margin and gross profit margin help you gauge your SMB’s profitability.
However, contribution margin helps you determine how well a particular product or service benefits or harms your bottom line. Gross profit margin helps you determine how well your SMB performs overall because it takes into account all COGS, not just variable costs.
You might think of it as looking at your SMB’s productivity through micro and macro lenses. Contribution margin is the micro metric, and gross profit margin is the macro metric.
Contribution margin examples
Next, we’ll look at a straightforward contribution margin example. Let’s return to the eCommerce SMB selling woven baskets. For this example, let’s say the time period is one quarter.
The SMB’s net revenue is USD200,000.
It has sold 5,000 baskets.
The price per unit is USD40.
The variable cost per unit is USD10.
Using the contribution margin per unit formula, subtract the variable cost per unit from the price per unit: USD40 minus USD10 equals USD30.
The contribution to profit per the contribution margin is USD30 multiplied by 5,000, or USD150,000.
The CM ratio is USD150,000 divided by USD200,000, which equals 3/4 or 75%.
How to use contribution margin in your business
You can use contribution margin to examine which products help or hurt your overall revenue. This boils down to basic logic. If a product doesn’t sell enough to justify its production expenses, then it’s wise to take one of three main actions:
Stop selling that product.
Decrease its variable costs (e.g. components, labour).
Raise the product’s price.
Each option comes with potential risks, of course.
For instance, a product may be consistently popular but not always sell in large quantities (i.e. a “cash cow”). In that case, stopping product sales would hurt revenue in the long term by cutting a regular cash flow contributor and hurting ROI.
Decreasing variable costs may lead to a lower-quality product that customers dislike or stop buying. Cutting variable costs may also lead to poor reviews, which hurt your SMB’s reputation. And naturally, raising a product’s price (even slightly) can turn customers away altogether.
However, you should take into account other KPIs before making any sweeping decisions. It’s certainly wise to double-check what you have listed as fixed and as variable costs — like we said, the categories can be tricky. Examining your revenue through a micro lens alone won’t give you a complete financial view.
Although contribution margin is definitely important, it’s only one piece of a much larger picture.
Speaking of larger pictures, via contribution margin analysis, you can take the same concept and apply it to teams, divisions and other aspects of your SMB. But that’s a matter all its own. For now, let’s stick with the product level — it’s closer to the heart of eCommerce.
How investors use contribution margin
As if you needed another reason to examine contribution margin, investors look at it to determine whether an SMB uses its funds effectively.
If an SMB has a high contribution margin, then it likely makes more money than it spends. Likewise, if an SMB has a low contribution margin, then it probably spends more money than it makes.
You can see why this would make a major difference to investors. If an SMB doesn’t use its funding wisely or doesn’t make enough money, then it’s not worth investing in. Savvy investors would steer clear of an SMB with consistently poor contribution margins.
What is a good contribution margin?
The best way to view a “good” contribution margin is through the CM ratio. When the percentage is close to 100%, that’s a good contribution margin. In short, the higher it is, the better your SMB is performing.
Your SMB probably has sound chances of covering its fixed costs when its contribution margin is close to 100%. And when you can cover your fixed costs, you’re closer to making steady, higher profits.
[Related: How to write a killer business plan]
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