Running an ecommerce brand today is more complex than ever, particularly for businesses striving to outpace their competition. After COVID-19, achieving profitability at a competitive cost has become a daily challenge. Therefore, understanding financial metrics is essential for any business aiming to thrive. Among these metrics, the contribution margin stands out as a crucial tool for assessing profitability.
Unlike simply tracking revenue or Return on Ad Spend (ROAS), the contribution margin provides a comprehensive view of your business’s financial health, especially for Direct-to-Consumer (DTC) brands. By understanding and effectively using this metric, brands can make informed, profitable decisions that fuel growth, while agencies can sharpen their strategies and enhance client discussions.
We’ll break down each component and highlight powerful tools, like the Contribution Margin Calculator and the Breakeven ROAS calculator. These resources will ensure you have everything needed to streamline your financial analysis and dominate the ecommerce battlefield.
What is Contribution Margin?
The contribution margin is a critical financial metric that measures the profit remaining after all variable costs, including marketing expenses, have been deducted from gross revenue. To clarify, it’s the amount of money your business retains from each sale after accounting for the costs directly associated with generating that sale. These costs usually include product costs, shipping, transaction fees, and marketing expenses.
Unlike gross profit, which only considers the cost of goods sold (COGS), the contribution margin offers a clearer picture of how much profit is generated after marketing expenses—one of the most variable and controllable costs in ecommerce. Understanding this metric is vital when optimizing your business performance with key ecommerce metrics.
“Contribution margin is the profit that each order is contributing to your business after marketing costs—it’s a better North Star for running the business with a profit orientation.” – Karl O’Brien, StoreHero co-founder
If you are seeking a more in-depth explanation, we recommend watching the video where Karl and Thomas, our StoreHero co-founders 🦸♂️, provide a detailed breakdown.
Difference Between Contribution Margin vs Gross Margin
When it comes to ecommerce metrics, one of the first questions is ”are Gross Margin and contribution Margin the same?” As you are already guessing, they are not.
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Gross Profit:
This is the actual profit your business earns after subtracting the cost of goods sold (COGS) from total revenue. It indicates how much your business earns after accounting for the direct costs of producing and selling goods, but before deducting operating expenses, taxes, or other indirect costs.
Gross Profit = Total Revenue – COGS
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Gross margin
It is calculated by subtracting the COGS from total sales revenue, showcasing the profit before operating expenses are deducted. However, gross margin doesn’t account for other variable costs like marketing, which can be significant in ecommerce.
Gross Margin Formula = (Revenue – Cost of Goods )/Revenue
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Contribution margin
On the other hand, CM provides a more accurate picture of profitability because it accounts not only for the primary costs of producing goods but also for those additional variable costs that often go unnoticed when calculating gross profit. These can include:
Contribution Margin Formula = Net Sales – COGs – Marketing Spend
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- Product Costs
- Shipping and Delivery Costs
- Fulfillment
- Transaction fees
- Packaging Costs
Essentially, while gross profit and gross margin helps you understand product profitability before marketing, contribution margin tells you how much profit you’re actually making after all direct costs are considered. This makes the contribution margin a more actionable metric for decision-making in the ecommerce space.
Why Shift Focus from ROAS to Contribution Margin?
For years, ROAS (Return on Ad Spend) has been the go-to metric for ecommerce businesses to evaluate the effectiveness of their paid marketing. While ROAS provides insight into the revenue generated per dollar spent on ads, it doesn’t offer a full view of profitability, especially when considering the full Profit First approach. As a result, many businesses are turning to contribution margin for a more comprehensive assessment.
“ROAS is a great metric to measure campaign and channel level success, but if you’re looking to understand the impact of your paid marketing on a business level, it’s a really terrible metric to gauge success. It doesn’t take into account any of your costs, and there’s a significant issue with attribution, leading to over-inflated conversion values and double counting.” – Thomas Gleeson, StoreHero Co-founder
With increasing concerns about attribution accuracy, unit economics, and the real cost of customer acquisition, businesses need a more reliable indicator of success. This is where the contribution margin becomes invaluable.
For example:
For example, let’s consider two online stores, Store A and Store B:
- Store A spends €1,738.82 on marketing and generates €11,734.22 in total sales. The COGS is €2,265.43, and after deducting other operating expenses, they achieve a contribution margin of €5,843.03, resulting in a profit.
- Store B also spends €1,738.82 on marketing and generates €11,734.22 in total sales. However, their COGS is much higher, at €7,000, and after deducting operating expenses, they end up with a loss.
Both stores have similar marketing efficiency, as measured by ROAS. However, while Store A is profitable, Store B is not. If you only looked at marketing spend and sales revenue, you might think both stores are performing equally well. Yet, Store B is in financial trouble.
Four possible scenarios:
Here are four possible scenarios illustrating the relationship between ROAS and contribution margin:
ROAS Increases, Contribution Margin Increases.
In this scenario, both ROAS and contribution margin are rising. Consequently, this indicates that your ad spend is efficient and profitable. Higher ROAS means that each dollar spent on ads is driving more revenue, thus contributing positively to your bottom line after covering all variable costs. This is the ideal situation where your marketing efforts align perfectly with business profitability.
ROAS Increases, Contribution Margin Decreases.
Here, ROAS is increasing, suggesting that your ads generate more revenue per dollar spent. However, despite this success, the contribution margin is decreasing. This means that while your ads are more efficient, other factors in the business, such as shipping or product costs, are negatively affecting profitable sales. The increase in ROAS might be due to low-margin products or external factors like discounts, which boost sales but ultimately erode profitability. Therefore, this scenario highlights the danger of relying solely on ROAS without considering its impact on overall profitability.
ROAS Decreases, Contribution Margin Increases.
In this case, ROAS is decreasing, implying that your ads are less efficient and generating less revenue per dollar spent. Nevertheless, the contribution margin is increasing, suggesting that despite the lower efficiency, your profitability is improving. This could be because you’re focusing on higher-margin products or more targeted campaigns, where even a lower ROAS is sufficient to drive significant profits. It’s a sign that, sometimes, a lower ROAS can still be part of a highly profitable strategy.
ROAS Decreases, Contribution Margin Decreases.
In this scenario, both ROAS and contribution margin are falling. As a result, it’s a clear signal that your marketing strategy needs a serious overhaul to regain both efficiency and profitability.
While chasing higher sales numbers is tempting, it’s important to remember that not all sales are equally valuable. Therefore, by using contribution margin as a guiding metric, businesses can ensure that their marketing efforts are not only driving sales but also contributing to sustainable, long-term profitability.
The Contribution Margin Formula Explained
Contribution Margin Formula = Net Sales – COGs – Marketing Spend
- Gross Margin: This is calculated by subtracting the cost of goods sold (COGS) from total sales revenue. It represents the profit before deducting operating expenses.
- Marketing Spends: These are the costs associated with promoting and selling products, including advertising, promotions, and other related expenses.
“Marketing spends are a critical part of your variable costs, especially in ecommerce. They can significantly impact your contribution margin, so it’s essential to track them accurately.” – Karl O’Brien, StoreHero co-founder
Step-by-Step Calculation of Contribution Margin
Imagine you run an ecommerce store that sells customized T-shirts. Last month, you generated $50,000 in sales revenue. The cost of goods sold (COGS) was $20,000, and your marketing spends amounted to $10,000.
Step 1: Identify and Calculate Variable Costs
- The sales revenue is $50,000.
- COGS: $20,000
- Marketing Spends: $10,000
Step 2: Apply the Contribution Margin Formula
Contribution Margin = Gross Margin – Marketing Spends
First, calculate the Gross Margin:
- Gross Margin = Sales Revenue – COGS
- Gross Margin = $50,000 – $20,000 = $30,000
Then, subtract the marketing spends:
Contribution Margin = $30,000 – $10,000 = $20,000
Step 3: Calculate Contribution Margin Ratio
Finally, calculate the contribution margin ratio. Understanding this is equally important. This ratio helps businesses understand the percentage of each dollar of revenue that contributes to fixed costs and profit.
(Contribution Margin /Sales Revenue ) x 100%
Contribution Margin Ratio = ($20,000 / $50,000) x 100% = 40%
This means that 40% of your revenue is contributing to covering fixed costs and generating profit.
Tools and Resources
We understand that all this can be overwhelming. However, if you have reached this step, well done! You are on the way to growing your business profitably. To streamline the process of calculating and analyzing contribution margins, we can help you with various resources and tools to simplify your life.
- Free Contribution Margin Calculator: This tool allows you to quickly and accurately calculate your contribution margin. As a result, you’ll have the data needed to make informed decisions.
- Free Breakeven ROAS calculator use this tool to determine the minimum ROAS required for your Facebook, Google, and TikTok ads. Consequently, you can cover costs and start generating profit.
But, if you want to make your life even easier, you can book a demo with us and start your free trial with the StoreHero platform.
These tools not only save time but also improve the accuracy of your financial data. In conclusion, they lead to better decision-making and more favorable business outcomes.
