As my previous blog suggested, gross margin is a critical profitability metric. Yet, it should not be looked at in isolation. A 50% gross margin on an ecommerce product may seem adequate, but it is only part of the picture. What if your selling expenses are high? You need to look at your contribution margin instead.
What is a contribution margin?
A contribution margin is a business’ sales revenue less its variable costs. Unlike a gross margin, the contribution margin factors in more than just the classic COGS or Costs of Sales variable expenses. As defined by Forage.com, a business’ contribution margin is its net revenue minus these (among other) variable costs:
Raw materials for production
Machinery maintenance costs
Direct labor expense
Commissions paid to salespersons
Shipping, freight, and fulfillment costs
I have highlighted the commission line above as it reflects a traditional, “feet on the street” view of variable selling expenses. Now, of course, those variable selling expenses also include Amazon fees, affiliate fees, licensing/royalty fees, and the like. These add up fast. Amazon referral fees will run around 15% of revenue. Non-Amazon, affiliate program fees vary. Should a sale be made through a given affiliate’s link, expect to pay from 5% -25% of the revenue generated. Goodbye 50% gross margin. Your contribution margin, the money left over to pay your fixed expenses, is more like 30-35% of net revenue, perhaps less.
When I worked at Chiquita Brands, contribution margin was primary; it was the profitability after determining “what it really cost to generate a particular sale.” Net Revenues – (COGS + Direct Selling Expenses). We did not include advertising expenses in our contribution margin calculations. We viewed advertising as a fixed or semi-variable expense, considering it part of operating expenses, “below the line.”
My business partner, Han van Putten, worked as an executive at Gillette. Gillette did include advertising expenses in its contribution margin calculations. Why? Gillette’s massive, continuous, advertising expenditures, while not purely variable, were critical to generating company revenues. To bury them in operating expenses as part of SG&A would be to ignore the true costs of generating those sales.
So, don’t get bogged down in definitions: Is an expense variable, fixed, or semi-fixed? Just price your products/services with its contribution margin, in mind: How much money will you have left over from a particular sale after factoring in all the direct costs it took to generate that sale? That will determine how much money is left over to cover your operating expenses.
In my next blog I will look at EBITDA and EBIT, the money that is left over from your contribution margin after paying your operating expenses. These are two measures of profitability that every business owner should understand.