For every e-commerce entrepreneur, understanding the financial metrics that drive profitability is crucial. One such metric that stands out is the contribution margin. It’s more than just a number; it’s a reflection of how efficiently a business operates, especially in the competitive Irish business market.
What is Contribution Margin?
It is a critical financial metric that reveals the amount of revenue left after deducting both the Cost of Goods Sold (COGS) and other variable costs from your sales revenue. It’s a clear indicator of how much you’re earning after covering the direct costs associated with producing and selling your products or services.
For businesses like yours in Ireland, understanding and optimising this margin is essential. It not only provides insights into your current financial health but also offers a foundation for strategic decision-making, ensuring sustainable growth and profitability
Around Finance teamed up with StoreHero.ai to provide some valuable insights following our guide on how to run a successful ecommerce business where they also covered the topic of contribution margin.
Why e-commerce stores should focus on Contribution Margin
There are several reasons why you should focus on this area, let’s take a look at a few:
Attribution problems: With multiple marketing channels in e-commerce, traditional metrics can sometimes be misleading. Contribution margin, being a direct metric, bypasses these complexities, giving a clearer picture of profitability.
Contribution Margin cannot lie: In the e-commerce world, where there are numerous costs like advertising, returns, and shipping, this margin provides a straightforward reflection of profitability after accounting for these variable costs.
Focus on profit over revenue: High revenue doesn’t always mean success in e-commerce. The contribution margin shifts the focus from top-line revenue to actual profit, ensuring sustainable growth.
Confidence and clarity when raising ad budgets: For e-commerce stores investing heavily in advertising, understanding this margin is crucial. It provides clarity on how much can be spent on ads while still remaining profitable.
Helps identify problems and opportunities within your online store: A declining margin can be an early warning sign of rising costs or pricing issues. Conversely, a consistently high margin might indicate opportunities for expansion or investment.
How to Calculate Contribution Margin
Wondering how to get to this number?
Contribution Margin = Sales Revenue – Full COGS – Ecommerce Variable Costs
Note: This margin essentially represents your profit after accounting for marketing, shipping, and production costs but before considering other operating expenses. It provides a snapshot of how much of your revenue is available to cover fixed operating costs and contribute to net profit..
If you need help trying to figure out how to apply this calculation to your e-commerce business then chat to one of our online accountants in Ireland.
Cost of Goods Sold explained
If you are trying to wrap your head around the calculation of the contribution margin, you might be wondering what exactly is included in COGS. Let’s take a closer look:
What is COGS?
It’s the total cost you spend to make the products you sell. COGS tells you the direct cost of creating your products.
What is included in COGS?
- Raw materials: The basic stuff you need to make your product.
- Direct labour: Wages for the people who make the product.
- Manufacturing overhead: Other costs tied to making the product, like machine power or factory rent.
What is not included in COGS?
Marketing costs, sales team pay, or delivery charges. COGS only looks at production.
How to Calculate Contribution Margin Ratio?
The contribution margin ratio is a handy tool that translates your contribution margin into a percentage. It tells you how much of your sales revenue is pure profit after accounting for variable costs.
Formula: Contribution Margin Ratio = (Contribution Margin / Sales Revenue) x 100
Using our previous example: If your sales revenue is €150,000 and your contribution margin (after deducting COGS and other variable costs) is €100,000, then:
Contribution Margin Ratio = (€100,000 / €150,000) x 100 = 66.67%
This means for every euro you earn, €0.67 is your profit after variable costs. In simpler terms, 66.67% of your sales revenue is pure profit after accounting for the direct costs of producing and selling your products.
Contribution Margin vs. Gross Margin
You might have come across both these terms in your financial reports or business discussions. At first glance, they might seem similar, but they serve distinct purposes in assessing your business’s financial position.
|Metric||Contribution Margin||Gross Margin|
|Definition||Amount left after subtracting variable costs from sales revenue.||Amount left after subtracting the cost of goods sold (COGS) from sales revenue.|
|Formula||Contribution Margin = Sales Revenue – Full COGS – Variable Costs||Gross Margin = Sales Revenue – Full COGS|
|Insights Offered||Shows how each sale contributes to covering fixed costs and generating profit.||Provides a view of basic profitability of products or services before other operating expenses.|
|Applications||Useful for assessing profitability of specific products/services, especially when variable costs fluctuate.||Essential for identifying inefficiencies in production or assessing direct costs.|
|Decision Making||Helps prioritise or discontinue offerings based on their contribution to overall profitability.||Useful in renegotiating supplier contracts, reassessing pricing strategies, or exploring cost-saving measures.|
Contribution Margin in different industries
The versatility of this margin is evident in its applicability across sectors. In e-commerce, it can guide pricing strategies, ensuring products are priced to cover costs and generate profits. Each industry has its unique set of challenges and cost structures. For example, e-commerce might have lower overheads compared to a brick-and-mortar store but might face higher logistics and return costs. Similarly, a marketing agency working on digital campaigns might have different variable costs than one focused on print or outdoor advertising.
Is the calculation the same across industries?
Yes, the fundamental calculation for the contribution margin remains the same across industries. However, what constitutes “variable costs” can differ widely based on the industry. For instance, a marketing agency might consider ad spend as a variable cost, while an e-commerce platform might look at shipping and packaging costs.
Improving your margin
Enhancing this margin is a continuous journey. Here are some steps to consider:
- Reassess pricing: Regularly review product or service pricing to ensure alignment with market demand and cost structures.
- Optimise costs: Identify areas where variable costs can be reduced without compromising quality.
- Strategic planning: Use the margin as a foundation for business strategies, ensuring decisions align with financial health.
The contribution margin is more than just a financial metric; it’s a tool that can guide e-commerce businesses towards sustainable growth and profitability. In the competitive online retail market, understanding and optimising this margin can be the difference between success and stagnation.
At Around Finance, our team of experts, from ecommerce accountants to specialists in various sectors, is dedicated to providing insights and solutions tailored to your unique needs, whether you’re in e-commerce, marketing, startups, or professional services. We’re here to ensure you have the financial clarity and guidance needed for your business’s success.