The foundational driver of profitability is your margin. Learn how to measure and optimize your contribution margin so that it doesn’t constrain your business as you scale up.
Scaling a DTC brand is complicated and overwhelming. Even worse, as the business grows, it becomes increasingly difficult to keep your finger on the pulse of your true margins. Margins are the lifeblood of your brand’s profitability. With low, unhealthy margins, everything – including growth – becomes significantly more challenging.
In this article, I will teach you the fundamentals of how to measure and improve your contribution margin. Contribution margin (not gross margin) is the often-overlooked margin metric that represents your brand’s true margin, and understanding it is critical to your scaling success. The result will be a newfound ability to proactively improve your margins, so you’ll never find yourself short of the profit and cash flow you need to fund your DTC brand’s growth.
The Basics: Contribution Margin 101
In its simplest form, contribution margin is revenue minus variable expenses. What the heck does this mean? Variable what? Let me take a moment to break this down in simple terms.
Variable costs are expenses that have a direct relationship with sales revenue. In other words, when sales revenue goes up, variable costs go up and vice versa. Another way I that like to think about it is this - variable costs are incurred every time an order is placed. A typical DTC brand’s variable cost structure usually includes the following:
- Cost of goods sold (COGS) – product invoice cost, freight in (shipping), import taxes and duties
- Freight out - shipping to the customer
- Fulfillment – 3PL or in-house pick/pack labor costs
- Payment processing fees – fees for processing credit card payments
- Advertising spend
Net Revenue (gross revenue minus discounts and refunds)
less Freight out
less Payment processing fees
less Advertising spend
= Contribution margin
So why does contribution margin matter? What does it tell you? In short – it tells you that when it comes to managing your margins you can’t just manage gross margin by focusing on reducing COGS. You must also focus on optimizing your fulfillment costs, freight out costs, and marketing spend efficiency. Now that you have a basic understanding of your contribution margin, it becomes much easier to break down the specific areas where you can improve your margins. Here are a few margin improvement tips that I commonly advise my Fractional CFO clients on:
Tips for Improving Freight Out Costs
- Re-negotiate carrier rates based on your most recent sales volume. Your current shipping rates are likely based on old order volume data. If it’s been 6+ months since your last rate negotiation, pull fresh data on your shipping volume and use it to negotiate better rates with your 3PL or carrier rep.
- Pro-tip: if your brand is growing steadily, sell them on your forecasted sales volume. You’d be surprised how easy it can be to get your 3PL or carrier rep to bring rates down based on future expectations (as opposed to historical data.) They’re in a commoditized industry with lots of competition and they want the business from your growing brand. So remember – if you’re growing, you have leverage!
- Optimize your fulfillment center mix. Are you currently only fulfilling out of a single warehouse? Analyze the cost reductions you’ll see by moving to two locations, one in the West and one in the East. Currently fulfilling out of two locations? How will freight out improve if you move to a three-warehouse network? Working with a 3PL that has multiple warehouse locations makes this strategy a lot easier to deploy than you think.
- Shop pricing with other 3PLs. Sometimes just going out to the market for pricing will get your current 3PL to bring pricing down. It’s cheaper for them to keep you than acquire someone new to replace your business!
Tips for Improving Ad Spend Efficiency
- Deploy a full-funnel marketing approach. What does this mean? It means that you can’t just fill the top of your funnel at a 2-3 ROAS with ads and expect great contribution margins. Instead, you need a strategy with touchpoints throughout your entire marketing funnel. Deploy tactics that drive repeat purchases through retention tactics like email/SMS and new product introductions that drive Lifetime Value (LTV). The moral of the story is this – to optimize ad spend efficiency and drive margin improvement, you need to drive repeat purchases from existing customers, not just first-time customers. Do this well and you’ll see your ad spend efficiency and margins increase.
- Consistently test new creative to reduce ad fatigue. High-performing evergreen ads are great, but in reality, ads don’t work forever. You need a process for consistently testing new ad content and doubling down your spend on the ones that win.
- Develop a process for testing new ad channels. Once you’ve reached the ceiling of a given advertising channel, your efficiency and your margins will begin to decrease. If this is the case, then it may be time to start testing new ad channels that can drive better efficiency and thus improve your contribution margin.
Armed with an understanding of your contribution margin and several tips for improving it, your future, profit-rich business awaits you! Don’t delay, get started now! If the thought of diving into your financial data to break down your contribution margin overwhelms you, and you don’t have a CFO on your team, consider hiring a Fractional CFO to help.
At Free to Grow CFO we give founders of growing DTC brands the Executive-Level CFO advice, insights, and strategies they need to scale alongside healthy profit, cash flow, and personal confidence. And – measuring and improving contribution margin is one of our specialties.
Book an intro call today if you’re ready to learn more about how we can help you successfully navigate your scaling journey.
Whether you choose to enlist the help of a Fractional CFO or take a stab at it alone, embarking on the journey of improving your growing brand’s margin is guaranteed to be a meaningful and worthwhile step toward achieving your growth goals.
Until next time, scale on!