Sell for $20 with $14 in variable costs and you keep $6, a 30% contribution margin. That $6 is what funds payroll, rent, and software before anything becomes profit. Stephen Brown explains why your operating margin can never beat that number, what a contribution margin at or below zero means, and how to divide fixed costs by the ratio to find the revenue where you break even.
Profitability
Ecommerce Contribution Margin Explained
4 min
Transcript
0:00 Variable versus fixed costs
Hi, I'm Stephen with LedgerGurus, and in this video I'm gonna talk about contribution margin. We will unpack everything you need to know to understand, calculate, and use contribution margin to optimize your profitability.
Let's start with the basics of contribution margin. Every sale you make brings in revenue, but not all that money stays in your pocket. To understand how much of that actually contributes to your operations and your profit, let's dive into variable and fixed costs.
Variable costs increase as your sales increase. Fixed costs, on the other hand, stay constant regardless of how much you sell. In the world of ecommerce, variable costs include things like cost of goods sold, fulfillment and shipping costs, payment processor fees, and advertising costs. These costs can be categorized as cost of goods sold, or cost of sales, or total cost of sales. Fixed costs would include things like payroll, software, rent, non-advertising marketing spend, and so on.
0:50 Why neither behaves perfectly
In theory, variable costs go up proportionately with sales and fixed costs stay constant. In reality, the variable costs vary and fixed costs do have to go up as your business gets bigger.
For example, you'll see different product costs by SKU or product item. Shipping costs can vary based on the product item, size, weight, or bundle of products. Payment processing fees can vary based on the credit card that the customer uses. Finally, advertising costs can vary by the month, week, day, and even time of day.
Fixed costs can't stay fixed forever. As your business grows, eventually you're going to have to increase those costs. They typically increase in step functions.
1:23 Calculating contribution margin
Calculating your contribution margin is straightforward. You simply subtract your variable costs from your revenue. What you're left over with is used to pay your fixed costs and ultimately generate a profit.
You can calculate contribution margin at the product item level, at the sales channel level, and ultimately at the overall business level.
Let's do an example at the product item level. Say that you're selling a product for $20 and the variable costs are $14. You're left with $6 in contribution margin. If you wanted to calculate a contribution margin ratio, you divide the $6 of contribution margin by the $20 of revenue, and that would give you a 30% contribution margin ratio.
2:00 Three takeaways
There are a few key insights to take away from contribution margin.
First, your profitability will never exceed your contribution margin. If your contribution margin is 30%, your net operating income ratio or operating margin ratio is never gonna be greater than that.
Second takeaway. If you have a contribution margin of 0% or less, you have a broken business. Your fundamental pricing and variable costs must change. You need to raise prices and/or decrease your cost of goods and/or decrease your cost of sales. Act quickly if you find yourself in this situation.
Third takeaway is you can use your contribution margin ratio and your fixed cost to determine a break even revenue point. For example, if you had a contribution margin of 30% and fixed cost of $300,000, to determine your break even revenue you would simply divide your fixed cost of $300,000 by your 30% contribution margin, which gives you a million dollars. At a million dollars in sales, you're break even. Anything above that should generate profit. As I mentioned earlier, reality is a bit messier, but this calculation will get you to the right target.
2:55 Where to track it
Finally, there is great benefit in tracking the contribution margin at the business level. There is also benefit in tracking the contribution margin at the sales channel level. This will allow you to determine if selling through Amazon or Shopify is generating the margins that you expect. Tracking contribution margin at the product item or SKU level can also be beneficial, but very time consuming. Start at the top, work your way down.
Calculating contribution margin requires good accounting, and in particular, accrual accounting. There's some additional videos in the comments that will help you with a lot of the concepts that I've discussed, if you want to go deeper on any of them.
If you need help determining your contribution margin, help with your ecommerce accounting, or just help with business advisory, reach out to us in the link in the comments. And if you found this video helpful, like it, ask me a question in the comments, and subscribe to our channel for more content like this.