Demand & Inventory Planning

How to Measure Contribution Margin and Why It Matters

Demand & Inventory Planning
January 25, 2024
10 min read

Measuring Contribution Margin enables you to maximize your business’s profitability at the SKU level and take control of its financial success. Learn why sales velocity does not always equal profitability in this guide to Contribution Margin.

What Is Contribution Margin?

Contribution Margin is the total revenue a product generates after variable costs have been deducted. The resulting revenue helps pay for your businesses fixed costs (sometimes referred to as “sunk costs”).

Ultimately, the higher Contribution Margin a product has, the more valuable it is to the longevity of your business. Savvy merchants will measure all the way down to the SKU level and find that, while an overall product category may have a low Contribution Margin, a specific colorway has a high one.

Contribution Margin Formula

While the formula is simple, finding the variables is relatively complex. The formula is as follows:

Revenue – variable costs = Contribution Margin

You can also measure it as a percentage of revenue by dividing the final number by total revenue:

Revenue – variable costs/revenue = Contribution Margin

Variable costs can be difficult to measure. Fixed costs are often one-time costs or standard operating costs that do not change with volume. Variable costs, on the other hand, change according to the volume of product being manufactured, sold, and delivered.

Examples of Variable Costs

Some variable costs decrease as volume increases. The classic example is volume discounts from suppliers. However, many merchants chase volume discounts at the expense of margin because other variable costs increase at higher volumes, including:

  • Transportation costs
  • Storage
  • Labor
  • Shipping rates and surcharges

To accurately measure Contribution Margin, it’s key to include all variable costs from production to final mile delivery.

Contribution Margin vs Profit

Gross profit is what’s leftover after all Cost of Goods Sold (COGS) is subtracted from revenue. It takes into account all overhead costs, while Contribution Margin only accounts for variable costs.

The value of calculating Contribution Margin is understanding how volume affects profitability. If Contribution Margin increases as sales increase, you know you have a product that will help your business grow sustainably.

How to Optimize Contribution Margin

To increase Contribution Margin, you can either increase the price of the product or decrease variable costs. For example, if you sell folding chairs for $25 each, with variable costs at $18, your Contribution Margin is $7.

25 (Revenue) – 18 (Variable costs) = 7 (Contribution Margin)

If you increase the price of the folding chairs to $27, you will increase the Contribution Margin to $9.

27 (Revenue) – 18 (Variable costs) = 9 (Contribution Margin)

Or, if you find a way to decrease the variable costs to $15, you will increase the Contribution Margin to $10.

25 (Revenue) – 15 (Variable costs) = 10 (Contribution Margin)

However, it’s important to find the right balance between price, quality, and profitability. If you increase your price by too much, you will no longer be competitive. If you cut variable costs to the extent that it damages the quality of your product, you can hurt your brand’s reputation.

McKinsey warns that chasing after margin with no consideration of consumer price tolerance or marketing spend, can eventually turn your highest performing SKUs upside down. If you can’t find the right balance, it may be best to simply cut that product from your catalog

Why Calculate Contribution Margin

When you understand at a SKU level which products are contributing to the profitability of your business, you can make more informed decisions around your product catalog. When only looking at gross profits, it can be easy to conflate sales velocity with profitability, but when you see Contribution Margin decrease as sales velocity increases on a particular product, you can quickly stop margin erosion.

On the other hand, you might be surprised which products have the highest Contribution Margin. You may choose to double down on sales of those products to drive more profitability.

The video below explains how, if you don’t calculate contribution margin at the SKU level, you could mistake sales velocity for growth and over time, “sell yourself out of business”.

Optimizing Variable Costs

Variable costs are sometimes hard to track and often more difficult to control. However, there is a major opportunity to optimize variable costs in supply chain and logistics.

Optimized Supply Chain Costs

When you have a tight control on your supply chain operations, you will begin to see three major efficiencies that will improve variable costs and increase Contribution Margin.

1. Inventory in the right place at the right time

  • No more long-zone shipments or costly overnight air to maintain marketplace SLAs
  • No more costly stockouts or inventory obsolescence

2. Profitability across all sales channels

  • No more lost margins in the battle for the Buy Box
  • No more lost sales from feeding inventory to the wrong channels

3. Lower Customer Acquisition Costs (CAC)

  • No more overpaying for Cost per Click (CPC) ads in locations with poor conversion rates
  • No more lost customers due to poor service levels

Measuring “The Key Three”

There are three major variables that drive the effectiveness of sales and marketing campaigns and in turn, the variable costs of a sale. It’s important to keep all three variables balanced to optimize costs. They are:

1. Price

Is your price low enough to win the Buy Box, but high enough to maintain your profitability goals?

2. Discoverability

Is your SEO and digital advertising optimized so high-intent shoppers are actually finding you in search or marketplaces?

3. Content

Are your product photos/videos and descriptions eye-catching and accurate while capturing the proper converting keywords? Do you have enough excellent reviews across all platforms?

None of The Key 3 exists in a vacuum. Each affects the other, and together they have a major impact on your bottom line. For example:

  • You’re being priced out by a competitor, so you lower your price but don’t run a digital ad campaign, so your product isn’t discoverable. You can lower your prices all day, but if no one sees your listing, you’re not making any sales.
  • You’re highly discoverable but have bad reviews, causing shoppers to scroll right past your listing to a more trusted vendor.
  • The only lever you’re pulling is pricing, constantly repricing to have the lowest price listing and eating up your margins.
  • You try to fix your discoverability problem with an expensive digital ad campaign, losing even more margin.

How Supply Chain Reporting Can Help

Between the rapid growth of ecommerce and low barriers of entry for digital sales channels, some merchants are at the crest of a wave without any real understanding of what’s holding them up. 

Launching multiple online channels and funneling in buyers has never been easier, but if you aren’t careful, you could easily sell yourself out of business. You could potentially coast on high volume, low profitability sales for 2-3 quarters without realizing that those sales actually have a negative Contribution Margin and are eating away at profitability.

With time, you’ll start to see a bottleneck in your cash flow. You’ll start negotiating for more flexible payment terms with your vendors and worrying about making payroll each month, and you’ll wonder why because your sales volumes are high.

Traditional sales and marketing reporting will not give the full picture of your variable costs or help you understand your profitability at the SKU level. In order to truly measure Contribution Margin, you must also include supply chain data through an aggregated Warehouse Management System (WMS), Transportation Management System (TMS), and Order Management System (OMS).

Ware2Go, a UPS Company, offers in-depth supply chain reporting and business intelligence to help merchants of all sizes make more informed decisions to drive the profitability of their business.

To learn more about Ware2Go’s supply chain technology, read about our solutions here. To stay up-to-date on the latest supply chain trends, sign up for our monthly newsletter here.

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