Contribution Margin (CM) = Revenue - Variable expense
CM% = (Revenue - Variable expense) / Revenue
There are 2 levers that can be pulled in a business to drive more net profit and Contribution Margin is one of them (the other being “fixed expenses”). This measurement might sound complex but it’s not. In fact, it’s both easy to calculate and just so happens to answer most questions around how you should use advertising dollars, whether it makes sense to create new products, execute a distribution deal, or expand the business–and a lot more.
The contribution margin dollars metric is calculated by subtracting the variable expenses from revenue. Using the same example as above, the company would have earned $4,900 contribution margin dollars ($10,000 revenue – $5,100 variable expenses).
In order to convert that to a true margin, just divide the total by the revenue to get to 49 percent.
What do you do with that information? Well, this is where the magic happens. Contribution margin is the amount of revenue that contributes to paying for the fixed expenses in the business and, if the fixed expenses are fully paid for (meaning that there are more contribution margin dollars than fixed expenses), the additional contribution margin is net profit.
An important question to ask: is the activity that you’re considering going to add contribution margin dollars to the business? And how can we make those contribution margin dollars more impactful and move into net profit faster?
Better yet, let's just test it and see what happens in real-time. Just head to Pentane's Guidance System, click the "Net Profit" tab and select one of the "Contribution Margin $" filters -- D2C is a important place to start as it answers questions around whether marketing, the new ad agency, testing free shipping, price increases or discounts, etc are working. At the end of the day, the Total Contribution Margin $ are what determines Net Profit, so watch that too.
Set your date range, making sure that you're not zoomed in too close (i.e. looking day-over-day is interesting but not super useful, so be sure to look over at least a week, preferably 2-4 or more). Then add a trend line over the graph to see how CM$ are trending.
Is your trend line going up over time? If yes, great! But don't stop optimizing, let's get that sucker as steep as possible! Just be sure you're not adding fixed expenses at the same rate, otherwise your just treading water from a net profit standpoint (or worse).
If your trend line is flat or decreasing, something (or a number of somethings) are broken. Look first at customer acquisition systems, channels, and costs -- generally this is where things get out of hand.