Why don’t entrepreneurs set up a simple Contribution Margin case before getting started?
This question has been daunting me for quite some time now. In the last few years I have come across a great number of highly skilled experts and entrepreneurs. When they speak about their businesses, their eyes light up, you can feel the energy and passion in their voice. It is an absolutely thrill to work with these people.
Most of the times, they ask me about very specific aspects of digital businesses or marketing. Such as: “How do I setup my remarketing campaigns?” or “could you help me with my social media?”. If so: “how much would that cost? & how much would I need to invest?.” Although the businesses have changed, my first response has not over the last couple of years. At the core of things, I always ask them one simple question: what are your affordables?
The one affordable that still interest me most, is the second contribution margin (CM II). Why not look at the whole picture? Well it is very simple: When you do not lose any money from a per purchase variable cost perspective, you have a good chance of running a profitable venture. When the CM II margin is right, it is all about finding the right scalable marketing channels.
A straight-forward contribution margin calculation looks something like this (example online Fashion Retailer – numbers are fictional):
CM I calculation
You sell your product (a jeans for example) at a gross price of 200 EUR (that is including VAT). In fashion, most retailers work with a “factor” on the cogs (product price). In this case for the jeans the retailer has a factor of 2.5x. This means that it has purchased the jeans for 200 EUR / 2.5=80 EUR cogs.
The CM I (or any margin calculation for that matter) is done on a net-basis. That means: we need to deduct the sales tax from our revenue. In this case: 200 / 1.20 = 166 EUR net revenue.
The CM I is determined by subtracting the cogs from the net revenue. In our example: 166 EUR – 80 EUR. This is the pure product margin that we have on our revenue. It can also be described as our marketing affordable (although we have to be careful with that phrase, because we have not accounted for other variable cost just yet).
CM II calculation
In order to calculate our true marketing affordable, we must first deduct all variable expenses related to the purchase. These variable expenses are for example: shipping cost, payment service provider cost, packaging, pick and pack cost, and the cost of returns handling.
From our 86 EUR net CM I margin, we need to deduct:
- Shipping: 4 EUR
- Pick and Pack (15 min. @30 EUR p/H) 7.50 EUR
- Payment Service Provider Cost (3%) 5 EUR
- Cost of returns (shipping and handling – Customer Service) 15 EUR
- Packaging 5 EUR
A grand total of 36.50 EUR variable expenses. If we deduct these variable expenses from our CM I margin, we are left with 49.50 EUR that we can spend on Marketing. Which in our example is quite a bit!
If we were to spend this full amount, we would not have any money left to cover for our overhead – and we would be making an immediate loss. But this is where the entrepreneurial thinking starts.
If you know how much you can spend on Marketing and Sales, you need to have a look at your fix cost basis to determine the amount of sales you would need at a full or respective contribution margin. Understanding your CM IIs is essential to running a business with success. When you are just starting out and are trying to bootstrap you company, you can use this insight to determine how many sales you will need to make. Next to that, you can calculate exactly how much you can give your affiliate partner (or spend on performance marketing) without making a loss.
The bottom line – Contribution Margin Rules
In essence, understanding your variable cost margins will enable you to make better marketing decisions. So sure, feel free to ask me what it would cost to setup an Adwords campaign or two. But be sure to know that the first thing that I will ask you is: what is your Contribution Margin II affordable. Then we can calculate exactly if it makes sense to invest in this channel, or not.
At GANDT Ventures, this has become one of the core values of the ventures we build. Transaction based performance marketing is a bit of an art in itself, but it is one of the safest bets to running a business with success. For me and for us, it is not all about top-level growth but about running a business with success.