Contribution Margin - Why It Matters To Unlock Growth

Hey team,

If you are wondering why your eComm store profits are not growing faster - then read on!

I am about to introduce you to a metric that could change the entire way you think about your business. And that metric is not ROAS.

Running a business isn't just about making sales, it's about knowing exactly how much profit each sale brings in.

That's where contribution margin calculation comes into play.

This metric can help you determine your break-even point, and how much you can afford to spend to grow your customer base PROFITABLY.

What Is Contribution Margin and Why Does It Matter?

Contribution margin is the amount of money left over from sales after you've covered all your variable costs.

It's the chunk of revenue that contributes to covering your fixed costs and, hopefully, generating a net profit.

Think of it this way: if you're selling handmade jewellery, your contribution margin is what's left after you've paid for the materials, shipping costs, packaging and variable marketing costs like Meta ad-spend that are directly tied to how much product you are selling.

These leftover revenues are called ‘contribution margin’ and go towards paying your rent, utilities, and other fixed expenses, and hopefully will be enough to leave you some profit at the end of the month.

Understanding your contribution margin is crucial because it helps you:

• Make informed pricing decisions.

• Identify which products are most profitable.​​

• Determine your break-even point.

• Plan for future growth.

• Decide how much you can spend to acquire a customer (CAC)

The Basics of Contribution Margin Calculation

Now, let's get into the practicalities of contribution margin calculation. Don't worry, it's not as complex as it might sound.

Using the contribution margin formula is a great way to assess your company's profitability.

The basic formula for the contribution margin is:

Contribution Margin = Revenue - Variable Costs

Let's break this down with a real-world example. Say you're running a fashion store. For each pair of trousers, you sell:

• Revenue/price: £50

• Variable costs:

  • The cost to make the trousers in the factory: £20,

  • the cost of packaging: £5,

  • the media spend to get the sale (CPA or CAC): £20

Your contribution margin per unit would be:

£50 - £20- £5 -£20 = £5

This means pair of trousers ‘contributes’ £5 towards covering your fixed costs and generating profit.

Diving Deeper: Contribution Margin Ratio

While knowing the dollar amount is useful, sometimes it's more helpful to look at the contribution margin as a percentage. This is where the contribution margin ratio comes in handy.

The formula for contribution margin ratio is:

Contribution Margin Ratio = (Revenue - Variable Costs) / Revenue

Using our touser shop example:

(£50 - £20- £5 -£20) /£50 = 0.1 or 10%

This means that 10% of each sale contributes to covering fixed costs and profit.

Why the Ratio Matters

The contribution margin ratio is particularly useful when comparing specific products or services with different price points. It allows you to see which items contribute the highest percentage toward covering fixed costs and generating a high contribution margin.

The higher the contribution margin, the more money is available to cover the fixed costs of the business and contribute to profit. This can then give you an idea of your total product profitability.

Advanced Contribution Margin Calculation Techniques

As your business grows, you might need to use more advanced contribution margin calculation methods. Here are a couple of techniques I've found particularly useful:

Multi-Product Contribution Margin

If you're selling multiple products, you can calculate an overall contribution margin for your business. Simply add up the contribution margins for each product, weighted by their sales volume.

You would do this by taking the variable costs per unit for each product and subtracting that from the selling price of each unit sold. Then multiply that number by the total number of units sold for each product. Take each of those numbers and add them together to arrive at the total contribution margin for your business.

For example, if your coffee shop sells:

• 1000 cups of coffee per month (CM: £2.30 each)

• 500 pastries per month (CM: £1.75 each)

Your total monthly contribution margin would be:

(1000 £2.30) + (500 £1.75) = £3,175

Break-Even Analysis

Contribution margin calculation is key to determining your break-even point - the point at which your total revenue equals your total costs. Break-even analysis is an important part of financial analysis.

The formula is:

Break-Even Point = Fixed Costs / Contribution Margin per Unit

Let's say your coffee shop has monthly fixed costs of £5,000. Using our earlier example where each cup of coffee has a contribution margin of £2.30:

£5,000 / £2.30 = 2,174 cups

This means you need to sell 2,174 cups of coffee per month just to cover your fixed costs.

Common Pitfalls in Contribution Margin Calculation

In my years of marketing analysis, I've seen businesses make some common mistakes when it comes to contribution margin calculations.

Here are a few to watch out for:

Misclassifying Costs

One of the biggest errors is misclassifying fixed costs as variable costs or vice versa. Remember, variable costs change directly with production volume, while fixed costs remain the same regardless of how much you sell.

For example, the salary of your full-time barista is a fixed cost, even though they're directly involved in making coffee. The coffee beans, on the other hand, are a variable cost.

Ignoring Semi-Variable Costs

Some costs have both fixed and variable components. These are called semi-variable or mixed costs. A common example is electricity - you have a base rate (fixed) plus usage charges (variable). These costs vary depending on different factors.

For accurate contribution margin calculations, you need to separate these costs into their fixed and variable components.

Leveraging Contribution Margin for Business Decisions

Now that we've covered the ins and outs of contribution margin calculations, let's talk about how to use this information to make smart business decisions.

Pricing Strategies

Understanding your contribution margin can help you set competitive prices while ensuring profitability. If you know your contribution margin ratio, you can quickly calculate how a price change will affect your bottom line.

For instance, if you're considering lowering the price of your coffee from £3.50 to £3.25, you can calculate the new contribution margin:

£3.25 - £1.20 = £2.05

New Contribution Margin Ratio = £2.05 / £3.25 = 63%

This shows that the price reduction would lower your contribution margin ratio from 66% to 63%. You'd need to weigh this against the potential increase in sales volume to decide if it's a good move.

Product Mix Decisions

Contribution margin calculation can guide decisions about which products to focus on. Products with higher contribution margins are generally more profitable, assuming they have similar sales volumes. Your cost of goods sold is something you would look at here as well.

In the coffee shop example, if lattes have a higher contribution margin than regular coffee, you might consider promoting lattes more heavily or expanding your latte menu. If a particular product is not generating a high enough margin, you may want to consider discontinuing it.

Marketing Spend and Cost of Acquisition

It is useful to work out your contribution margin before your media spend is taken into account, as this gives you a clear picture of how much you can spend to acquire customers profitably.

For example, in our trouser example, the contribution margin before the marketing costs are taken into account is £25 (£50-£20-£5).

We can then use this to work out how much we can afford to spend to acquire each new customer while keeping the contribution margin positive.

In our example early our customer acquisition cost was £20. This left only £5 after all variable costs were subtracted.

So this exercise might lead the business owner to either raise their price to allow more margin, or to figure out if there is a way to lower their cost of acquisition.

The point of all of this is to have a model that gives you a clear target CAC (cost of acquisition) that will produce enough contribution margin to make you profitable.

If you got this far - congrats - you are now armed with a new metric to track that will tell you the health of your business as you grow!

To your success!

Jessie

ps. if this is all a bit much to get your head around - let’s jump on a call and look at your numbers together! I have a handy template I can share that can make it all come clear!

Book a free financial audit here