WTF is Contribution Margin and Why Does it Matter?
What the f*&^ is a contribution margin!? It’s one of the most potent indicators of a successful business. It’s a way of looking at your business and really dialing in what you have, what you need, and what you could be doing differently. Let’s get into it.
First, a simple formula.
Calculating Contribution Margin
Contribution margin = net revenue - all variable costs / net revenue.
That divide by the net revenue bit at the end is essential because the contribution margin is typically displayed as a percentage, so don’t leave that off!
So if you sold a magazine and generated $200,000 in net revenue, and the variable costs were $100,000, then your contribution margin would be…
Contribution margin = (200,000 - 100,000) / 200,000 :
Contribution margin = .5 or 50%
Net revenue you understand, but what are variable costs?
Variable costs can include fulfillment, cost of goods, advertising, and payment processing fees. Every bit of money you have to put into the product that isn’t a set, fixed price is a variable cost.
Now, we’re an advertising agency, so of course, we will expand on advertising as a variable cost. For one, it’s often going to be the highest variable cost – but it is also one you have some of the most control over. More on that later!
What’s a Good Contribution Margin?
The higher the contribution margin the better. You want your contribution margin to be closing in on 100% at that point; it means more money is available to cover the business’s overhead expenses.
Unfortunately, it’s more likely that the contribution margin ratio is well below that and probably even below 50%. So, how do you juice that number up?
Improving Contribution Margin
If your product contribution margins are low, it will affect your entire company’s contribution margin. When it comes to improving your contribution margin, you have a few options, reducing variable costs, increasing the price of services and products – or cutting those products entirely.
Eliminating lower contribution margin products can have an overall positive impact on a company’s contribution margin as a whole. But that also means you’re not making any money where before you were. Instead, it might be better to reduce variable costs, such as the raw material and cost of shipping. If those costs can’t be controlled, then raising the price of your products may be the right step to get those margins higher.
Another step? Work with the contribution margin you have. Lowering your fixed costs so that the contribution margin covers them easily may be the right step to improving your finances, even if the margin doesn’t change. Find a location with cheaper rent, eliminate unnecessary tools, etc.
Gross Margin vs. Contribution Margin – What’s the Difference
At first blush contribution margin may seem or sound similar to gross margin, but it’s more dialed in than that. Gross margin measures the amount of revenue that remains after subtracting costs directly associated with production. The contribution margin measures the profitability of various individual products based on the variable costs associated with those goods.
Contribution margin is just one type of profit metric, but it can have a real, marked change on your business. Work towards getting yours to 100% and reap the benefits!
How Contribution Margin Can Power Your Advertising Strategy
Alright, so we talked about advertising being a key variable cost. That’s because it is something very much in your control. Printers or shipping companies control their costs and you have to roll with them, but how much do you allocate to advertising? That’s yours.
Knowing contribution margins can help you maximize your efforts in advertising as well, which is why we’re fans of it here. You have a few approaches you can take, all of which will help focus your advertising and deliver results where they matter!
Option 1 - Focus Your Ad Dollars on High Contribution Margin Products and Services
If you have products that already have a great contribution margin – awesome! Putting more advertising dollars into campaigns pushing those products and contributing to a higher overall revenue. Nice.
Option 2 - Cut Advertising Where It Makes Cents
When advertising is the highest part of the variable costs, they may make for a low (or even negative) contribution margin. That’s a problem. Even if the product is your top seller, or brings in a ton of cash, that low contribution margin means it’s not making you nearly what you think. In these cases cutting advertising entirely and your business will get a better cash flow almost immediately.
Option 3 - Pivot Marketing, Look for Fixed Cost Approaches
For those products that have a low contribution margin due to advertising costs, after you’ve axed your current advertising approach, find alternate ways to market and advertise that product in ways that use fixed budgets so your contribution margin stays high.
You may move less of the product, but the more you do you have a higher contribution margin for, which all contributes to a higher cash flow for your business.
That was a lot. We know. We didn’t go get MBAs either. But we know how to make sure our clients are getting the best results, and that happens to include knowing contribution margins and how our efforts impact yours.