Decoding e-commerce Contribution: A Key to Understanding Your Profitability

Introduction

In the dynamic landscape of e-commerce, profitability is the ultimate goal. To navigate the complex web of metrics, understanding contribution margin emerges as a pivotal skill for businesses striving for sustainable success. In this blog post, we will delve into the intricacies of contribution margin, exploring its significance, calculation, and how it serves as a compass in guiding your business towards greater profitability.

Understanding Contribution Margin

Contribution is the money you have left after all variable costs have come off.

Contribution is a crucial financial metric that provides valuable insights into a company's profitability. It represents the portion of revenue that exceeds variable costs associated with selling goods or delivering services. Contribution margin aids businesses in making informed decisions about their marketing efficiency, product mix and pricing strategies.

The Contribution Formula

The contribution margin is calculated using a straightforward formula:

Contribution = Revenue - Taxes - Returns - Cost of Goods Sold - Payment Processing Fees - Fulfilment Cost - Marketing Spend

Contribution Margin = Contribution / Revenue excl. Taxes

Essentially, it is your profit before operating expenses are removed. Some brands choose to include all marketing costs, whether they are variable or fixed, within their Marketing Spend calculation. This is down to the brand’s preference.

Interpreting Contribution

A high contribution margin indicates that a significant portion of revenue is contributing to covering fixed costs and generating profits. On the other hand, a low contribution margin suggests that a larger proportion of revenue is being consumed by variable costs, leaving less to contribute to fixed costs and profits.

It’s more important than ever to have a view on your Contribution, to support you with understanding why it is up or down.

Significance in Contribution Focused Decision-Making

Product Mix Optimisation:

Contribution margin helps businesses identify and promote high-margin products, optimizing the overall product mix. By focusing on products with higher contribution margins, companies can enhance profitability and allocate resources more efficiently.

Pricing Strategies:

Understanding contribution margin guides pricing decisions. Businesses can set prices that not only cover variable costs but also contribute to covering fixed costs, ultimately leading to improved profitability.

Cost Control and Marketing Efficiency:

Contribution analysis facilitates a granular view of costs, allowing businesses to identify areas where cost control measures can be implemented. This helps in managing variable costs efficiently, safeguarding and improving profitability. Often, marketing spend is largest cause in fluctuations in profitability.
Therefore, it’s important to have a view on the trends associated with fluctuations in Contribution. For example, in a Facebook Ads first company, you understand that increased CPAs on Facebook are a huge factor in Contribution being down.

Question: Do you have a view on the correlation between your Facebook Ads CPA against Contribution?

Understanding the pattern of your Contribution against your marketing efficiency is crucial.

In this example, you can notably see that as Facebook CPAs increase, Contribution per order decreases, confirming the impact of the Facebook CPA on Contribution by day.The notable day to review here is the 25th of February. The CPA has increased to £24.45, similar to the CPA on the 22nd of February, a day where Contribution was poor. Although, the Contribution is significantly higher on the 25th. This showcases that Facebook was not the underlying cause of this increase in Contribution and was likely due to another channel, with low to no spend.The questions to ask in this instance:
Was there an email campaign sent on the 25th of February which caused an increase in profitable, low-cost revenue?
Was the average order value higher on this day?

In order to scale spend profitably, you need to understand what is impacting your Contribution positively.
As you scale spend, CPAs will increase. Therefore, your added contribution per order that's above target provides you with extra profit to invest into scaling spend at higher CPAs. Remember, your fixed costs come off after the final Contribution number. Therefore, you must have a target Contribution number which is enough to cover your fixed costs. This target will allow you to calculate your target channel-specific CPAs and your blended CPA.

Get this view plus 100s more with Requisite.

Break-Even Analysis:

Contribution is a key component in break-even analysis, helping businesses determine the level of sales required to cover both variable and fixed costs. This knowledge is essential for setting realistic sales targets and achieving profitability.

As well as a target CPA, you must understand what your maximum CPA target is to break even. From your maximum CPA target, you are able to calculate your minimum ROAS target too.

Real-world Examples:

To illustrate the practical application of contribution margin, let's consider a haircare company that produces two products: A and B.

Product A has a higher selling price and a higher CPA on Facebook Ads, resulting in a contribution margin of 30%.

Product B, despite a lower selling price, has a lower CPA on Facebook Ads, yielding a contribution margin of 40%.

Analysing the contribution margins, the company can strategically focus on promoting and optimising the production of Product B to enhance overall profitability.

References

Horngren, C., Datar, S., & Foster, G. (2006). Cost Accounting: A Managerial Emphasis. Pearson.

Hilton, R. W., Maher, M. W., & Selto, F. H. (2008). Cost Management: Strategies for Business Decisions. McGraw-Hill.

Drury, C. (2007). Management and Cost Accounting. Cengage Learning.

With Requisite Reporting, you can access 100+ pages of your eCommerce data, in an easy-to-digest format. This includes a breakdown of your Contribution.

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Conclusion

In the intricate world of business, contribution margin emerges as a key to unlocking profitability. By deciphering the insights it provides, businesses can navigate the complexities of product mix, pricing strategies, and cost control. With contribution margin as a guiding compass, companies can make informed decisions that pave the way for sustained success and growth.