DTC Briefing: Why brand operators can’t stop talking about contribution margin

Contribution margin isn’t a new concept, and it’s not the only metric a founder will track to measure how healthy a bottom line is. But the newfound obsession over contribution margin is indicative of the current business climate for DTC startups: there remains a much bigger focus on getting to profitability than growing at all costs. And tracking contribution margin more effectively is one way brands can grow more efficiently.

“I think people underestimate how important it is to focus people and organization on a number,” Jesse Pujji, founder of growth marketing-focused holding company Gateway X. That is, it can be a helpful exercise to have a team focused on growing and improving a single number, and contribution margin can be one of the more useful metrics because it takes into account a company’s bottom line. 

Margin mania 
Contribution margin is similar to gross margin. Both metrics account for how much money a company has left over after taking revenue, and then subtracting certain costs associated with selling a good. But gross margin takes into account the cost of goods, while contribution margin takes into account variable costs. 

What are variable costs? Anything that can increase or decrease based on the amount of units sold. A good example is shipping costs, since they can increase or decrease on a per-unit basis depending on how many units a brand ships. Cost of goods sold, meanwhile, is the sum of the direct costs of producing an item, such as labor and material costs. Not all variable costs are included in the cost of goods sold — payment processing fees are one such example. 

Dan McCarthy, assistant professor of marketing at Emory, said that there are a few common mistakes companies can make — implicitly or explicitly — to “cheat their way into a higher margin.” One is to essentially assume that gross margin is the same as contribution margin — or, assume that they are close enough that the difference doesn’t matter. Another is to “try to omit every possible expense if they can to make that contribution margin higher.” There are some costs that fall into a gray area — and ultimately, for privately held companies, it is at their discretion what costs they want to include as variable costs. 

Some companies, for example, will “deduct store expenses, like rent from their contribution margin, but other companies won’t,” according to McCarthy said. Rent can be a gray area because, while the cost of rent does technically increase as a company gets bigger — if they do more sales, they’ll likely need more stores — it doesn’t grow with each customer that walks in the door. Whereas something like shipping expenses increases with each sale. 

Contributing more dollars to the bottom line
Discussion of DTC marketing tactics is often dominated by acronyms like CAC, ROAS and LTV — terms that delineate how much it cost to bring a customer in, how much money an ad brought in and how much money that customer is projected to spend over his or her lifetime. While these metrics can be useful for for determining how effective certain parts of a business are, they have their limitations in trying to evaluate how healthy a business is overall. 

In the mid 2010s, founders often touted CAC and ROAS as chief metrics of success — particularly in the days when DTC darlings like Warby Parker and Casper advertised only through digital marketing channels. But some brands focused too much on how many customers they could acquire for cheap, and not enough on other parts of the business. These issues came to a head when some brands went public, and people could look more closely under the hood of DTC businesses.

Whoop’s Saljoughian wrote, for example, that Casper’s unit contribution margin suffered due to low repeat purchase rates and excessively high marketing spend. While Casper’s gross margin in fiscal 2020 was 51%, its unit contribution margin was 15%, which suggested that “after all variable costs were taken into account, there wasn’t a significant enough profit left to cover fixed expenses.”

Pujji gave the example of a company that sells two products that cost the same. But, one is more expensive to produce and heavier to ship than the other. A metric like ROAS just evaluates the success of an advertising strategy based on how much of each product is sold — not how much profit each product is contributing to the company’s bottom line. 

While gross margin and contribution margin are both important metrics, contribution margin can be more useful in per-unit or per-product analyses. It is useful in helping a business not only determine where they should cut costs, but also where the most efficient places are to spend to help grow sales. 

In his Medium post, Whoop’s Saljoughian laid out the hypothetical example of two companies that have the same CAC/LTV ratio, but one has a higher unit contribution margin (net of CAC). 

The one with higher margins “may have more flexibility and opportunities for growth,” and may want to ask themselves questions like “can they invest more in marketing to further accelerate growth?” or “is there room for expansion into new markets or product lines (R&D), given the cushion the profitability provides.” By contrast, the company with lower margins may need to ask themselves where they can reduce costs — or, if they need to increase prices — to improve their contribution margin. 

Chubbies’ Rutherford wrote on LinkedIn that focusing too much on revenue and not on contribution margin will “create situations where marketing thinks they are crushing it, but business fundamentals are suffering.” He wrote that when Chubbies started focusing more on contribution margin, it realized that “the only way to grow both contribution dollars and contribution margin” was to move away from 100% direct response marketing, and instead invest in a mix of both brand  marketing and direct response marketing, which would attract a customer that was more likely to pay full price. 

Ultimately, focusing more on contribution margin isn’t likely to yield some radical new insight that will completely turn around a fundamentally bad business. However, it will help already-sound businesses become healthier.

“The good thing about contribution margin is that oftentimes as firms mature, they’ll find ways to [just] do what they’ve been doing more efficiently,” McCarthy said. 

What I’m reading

• Rob DeMartini, CEO of mattress brand Purple, said at the ICR conference last week that managing stores was one of the company’s biggest challenges. “Two-thirds of them are working and a third of them aren’t,” he said. 
• It was a busy week for new C-suite appointments, as Solo Brands and Rothy’s both named new CEOs. 
• Rent the Runway ushered in the new year by cutting 10% of corporate jobs. 

What we’ve covered 

• Casper unveiled a new store design as it seeks to grow its retail and wholesale business as a now privately-held company.
• NRF’s Big Show wraps up today, and although it is a must visit event for many DTC brands, SMBs find they don’t get as much out of the event as tech vendors. 
• Food and beverage brands are tapping running clubs for sampling opportunities, in the hopes that members of these tight-knight groups will become enthusiastic early product adopters.