For e-commerce and D2C brands struggling with profitability, understanding contribution margins is the key to unlocking better decisions. In a world where marketing costs are rising and margins are thinning, knowing how CM1, CM2, and CM3 impact your bottom line is more crucial than ever.
The days are gone when it was "growth at any cost," and investors happily poured money into unprofitable, growing e-commerce companies. To survive, you need to understand and control your e-commerce's profitability. In this blog post, we'll discuss the key components of e-commerce profitability and what you can do to improve it.
At a glance, profitability might seem straightforward: revenues minus costs. It would be that simple if you sold one product, used one marketing channel, targeted a single audience, shipped to one country, and used one shipping provider. However, that's not the case. When you dig deeper, the complexities of e-commerce profitability begin to unfold.
The E-commerce Contribution Margin formula
Let's start with the Contribution Margin formula, i.e., E-commerce Operational Profits, looks like this
Net Sales = Gross Sales - Returns
Contribution Margin 1 = Net Sales - Cost of Goods Sold
Contribution Margin 2 = Contribution Margin 1 - Fulfilment Costs
Contribution Margin 3 = Contribution Margin 2 - Marketing Spend
What is Net Sales in e-commerce?
Returns play a more or less significant role in the Contribution Margin for different businesses. Some e-commerce companies, like Beauty and other niches, only have a couple of % percentage points in returns that result from incomplete deliveries. Other e-commerce businesses have higher return rates, ranging from moderate to high. High return rates quickly erode your margins. To improve, you need to understand what drives these returns and monitor them daily.
What is Contribution Margin 1 in e-commerce?
After accounting for the returned items, we can set the Cost of Goods Sold. Generally, Cost of Goods Sold includes the product purchase price plus transport and warehouse intake costs.
Therefore, your product's initial margin defines Contribution Margin 1, and any discounts will decrease it.
Then there's the discounts—a powerful tool to drive sales, but they can quickly diminish profitability if not managed correctly.
What is Contribution Margin 2 in e-commerce?
The dramatic variations in logistic costs between products and countries, including picking, packaging, shipping, and customs, are part of the complexity of creating your Contribution Margin 2. If you have that data, that's almost always a place to find low-hanging fruit when optimizing your e-commerce business' profitability.
This is your Contribution Margin 2, and its effect is both the actual costs at this stage and the Contribution Margin 1 that's left after COGS to carry the fulfillment costs. Look at this straightforward example of 3 different orders.
Order 1
Three smaller products in the basket with low initial Gross Sales but no discount, low returns, and good starting margin. Gross Sales of 300, Contribution Margin 1 200, and fulfillment cost of 50 result in 150 in Contribution Margin 2.
Order 2
One big product is in the basket with high initial gross sales, high discounts, low returns, and an okay starting margin. Gross Sales of 500, Contribution Margin 1 of 200, and fulfillment cost of 150 results in 50 in Contribution Margin 2
Order 3
Order 3 contains the same products as Orders 1 and 2 but is shipped to a country with higher return rates and shipping costs. Contribution Margin 1 is 300 (lower due to higher returns). Despite some fulfillment cost savings, higher shipping costs increase the fulfillment cost to 250, resulting in a Contribution Margin 2 of 50.
In this case, we can see that Order 1, with Gross Sales of. 300 was way better than Order 3, with 800 in Gross Sales.
That's the complexity of e-commerce in a nutshell when scaling globally.
What is Contribution Margin 3 in e-commerce?
Marketing costs are more commonly understood and analyzed than fulfillment costs in e-commerce. However, they are often assessed in relation to Gross Sales using metrics like Return on Ad Spend (ROAS) or Cost of Sales (COS).
To get our Contribution Margin 3, we take our Contribution Margin 2 and add our marketing spend. When done right, and when the whole commercial team (marketing and buying) is measured on Contribution Margin 3 instead of vanity metrics such as ROAS and GM1, this tremendously affects the way of working.
To continue on our example from above, given that why have the same Cost-Per-Order 50, a marketer measured on ROAS would have been incentivized to prioritize sales oppositely than what you want if you want to maximize profitable growth. The highest ROAS is on Order number 3 (800/50=16), and the lowest is on Order number 1 (300/50=6).
When measured on Contribution Margin 3, a marketer quickly sees that Order 2 and 3 yield 0 in Contribution Margin 3, and Order 1 yields 100. The marketer can then work proactively together with buying, and vice versa, and ask the vital questions for maximizing profitable growth
- Which products should we market in which countries?
- What is the ideal price point for our products in different countries?
- Given the general shipping costs, what is our minimum Contribution Margin 1 per market?
- Which countries yield the best contribution margin 3, and therefore should get the most marketing spend? (until worse countries' profitability issues are solved)
How to improve Contribution Margin 3 in e-commerce?
Given that all these costs aren't uniform. They can differ vastly between countries, products, and individual customers. This presents a unique challenge for an e-commerce business operating globally. How do you track and optimize these varying costs on a granular level when they fluctuate daily? Profitability lies beneath the averages; you can't expect to succeed without delving deeper. You need real-time answers at your fingertips to monitor the impact of your efforts to improve Contribution Margin.
Dema's e-commerce analytics platform provides all these insights and more in just a few clicks. You can perform deep analyses and save reports showing week-over-week changes.