Why Contribution Margin is Critical to Startup Founders

When you launch a new startup brand, you're typically looking at your accounting system on the regular. Are we growing? Are we making money? How's cash flow looking? Can I hire a C anything O yet and stop working 24/7? (Ahem, hiiii.)

One of the layers that sometimes doesn't get considered as closely as I'd like to see, having launched, scaled, and transformed 60+ consumer brands over the last 5 years, is a solid view of contribution margin by channel in brands operating on an omnichannel strategy. While it's obviously super important to understand the P&L as a whole, developing clarity around what sales channels are working and which are underperforming can help you set, reset, and refine growth strategy.

If the name of the game is capital efficiency, sales channel contribution margin is critical to smart growth.

Without further ado, let's take a contribution margin view on your individual sales channels:

• Gross sales
• Net sales
• Gross profit
• Contribution margin

A True View of Sales Channel Performance

There are a few different sales channel based metrics that you're going to want to be looking at regularly to understand what margin they're contributing to your business. (You can obviously look at contribution margin holistically for the business as well, but I find it to be most useful as a sales channel triage for decision making.)

Sales Channel Breakdown

For purposes of clarity, I would take a look at all of the following sales channels and break up as you see fit. You're generally trying to consolidate channels with similar revenue and cost structures. If you know that it costs you $25 per unit to ship to Canada and only $7 per unit to ship to the US, I would absolutely treat those as distinct channels with separate contribution margin to the business. If you know you need to rely on heavy discounting in Amazon UK but you don't discount at all in North American marketplaces, again, I'd consider combining North America and breaking out the UK. You get the point! 

Channels and breakdowns to consider:

• Shopify - consolidated, by region
• Amazon - consolidated, by region
• Marketplaces - consolidated, by format, by region
• Independent retail stores - consolidated, by format (single store, up to 10 doors, etc.), by region
• Distributor retail - consolidated, by distributor size, by region
• Owned stores - consolidated and by door
• And so on!

Why does contribution matter more than your P&L? Well, it's not that it does. It's that as a young business operating in more than one sales channel, you need to be smart and efficient with your dollars. If you learn that you're operating on a 25% net contribution margin basis for the Amazon channel and only a 15% net contribution margin basis for the independent retailer sales channel, what are you going to do?

Say it louder for the people in the back: in the early days (ahem, years) post-launch, you're going to prioritize the more profitable sales channel.

Over time, you'll start shifting decisions to diversify how you blend the channel mix, but in early days? Contribution margin is extraordinarily important and a key accounting measure you should be considering as you launch and scale.

Gross Sales

These are your top line sales. You set your price to $75 for a beautiful journal. That $75 represents a gross sales number if they buy one. If they buy two in an order, the gross sales on that order is $150. 

While gross sales don't represent the actual money coming into your bank at the end of the day, making them less important on a cash flow basis, gross sales do matter. They effectively represent the demand in market for your startup brand product, prior to considering any business activities and tactics to shift that demand in your favour. 

Net Sales

In a consumer product business, we would typically consider net sales as your gross sales minus discounts and returns, with shipping income added back in. 

• Your customer adds that beautiful $75 journal to her cart.
• She also has a 10% off welcome discount code, worth $7.50, bringing the order value down to $67.50.
• She doesn't qualify for your $99 free shipping, and has to pay another $15 in shipping, bringing the order value up to $67.50 + $15 = $82.50. That's the net sales figure for this order.

On a cumulative basis, let's say you have 100 of this exact same order, giving you $82.50 x 100 = $8250. However, you get 10 returns, which comes to $82.50 x 10 = $825.

This puts your net sales for the month at $8250 - $825 = $7425.

People often look at net sales as their most important top line metric in direct to consumer brands, since you effectively never earned the discounts or returns, and any earned shipping income is certainly real income.

The reason I think it's important to regularly look at both gross and net sales is that the difference between these two numbers should be (a) consistent, and (b) budgeted. You want to regularly monitor what percentage of gross sales that net sales represents and maintain consistency during the majority of the year, excluding major and intentional promo periods like BFCM.

Often, I see brands focusing entirely on net sales without accounting for the fact that they could have a very impact on their net sales simply by changing their promotional strategies, taking action to reduce returns, or shifting shipping threshholds. If you don't notice that the difference between gross and net sales is increasingly slightly every month, you could miss the window to remedy things before they get out of hand.

Gross Profit

I'd typically define gross profit as net sales minus cost of goods and freight/brokerage/warehouse fees. Basically, the variable costs required to get that product into your customer's hands.

• Your customer adds that beautiful $75 journal to her cart.
• She gets the 10% discount and pays for shipping, per the above, resulting in a net $82.50.
• The journal cost $25 to manufacture locally, saving you brokerage fees but nonetheless bringing the gross profit down to $82.50 - $25 = $57.50.
• Your warehouse charges $5 per order plus $0.50 per insert, and you include a refer a friend card, bringing the gross profit down to $57.50 - $5.50 = $52. 
• You know it costs $15 to ship - you've passed that cost directly to the customer without applying any mark - and you need to account for that, bringing gross profit to $52 - $15 = $37.

In this example, your individual order gross profit is $37, which is 37/75 = 49.3% of gross sales. However, let's look on a cumulative basis again - for your hundred orders with ten returns that came to $7425 in the net sales example above, your gross profit would be $37 x 90 non-returned orders = $3330. (You may actually need to consider the other 10 returned orders as part of the cost of doing 100 orders if you're not able to effectively re-sell them, adding 1/10 of the cost of every journal as an incremental cost to every sale - but that's a whole different topic on returns management!)

What does that leave us with? $3330 / $7425 = 44.8% gross profit.

Everybody cares about gross profit because we're always trying to improve profitability, and the things that hit your gross profit tend to be direct costs that are super overt. You can't sell a product without paying for a profit. When we look at the business as a whole gross profit can look strong - the question you can be missing if you don't ladder down one more level is whether your sales channels are operating where you want them to be.

Contribution Margin

The contribution margin is what remains when you take that $3330 in gross profit and then subtract out the infrastructure costs of running the associated sales channels.

On a direct-to-consumer brand, this can include direct digital marketing, as well as the cost of producing creative and content for use in site, social, email, and ads. It can include your Shopify fees and your Amazon fees. Basically: anything you have to pay for because you're operating on a sales channel.

• You've sold 100 journals, had 10 returns, and achieved a gross profit of $3330.
• Shopify cost you $200. ($3330 - $200 = $3130.)
• Klaviyo cost you $100. ($3130 - 100 = $3030.)
• You spent $1000 advertising on Meta and Google. ($3030 - $1000 = $2030.)
• You hired a freelancer to shoot the photos for the month to use on site, social, email, and ads, for $500. ($2030 - $500 = $1530.)
• This gives you a contribution margin of $1530. Your contribution margin as a share of gross sales is $1530 / $7500 = 20.4%. Your contribution margin as a share of net sales is $1530 / $7425 = 20.6%.

This hasn't gotten into your overall costs of running the business, rather simply the contribution margin of a single sales channel. But understanding the performance of your various sales channels is super fricking important for any brand operating with omnichannel strategies and/or aspirations.