Costs are skyrocketing in nearly every sector as inflation continues its march upward. Inflation is the highest many of us have experienced in our lifetimes.
In response to rising prices, both businesses and consumers are minimizing spending wherever they can, as well as shopping around for deals. Governments are raising interest rates as they attempt to slow down demand, but concerns about an imminent recession abound.
This perfect storm is creating higher costs within your business while putting pressure on your end pricing to consumers, so let’s talk about contribution margins.
We recently had the opportunity to connect with Eric Ashman, former President and Chief Operating Officer of Group Nine Media, one of the world’s largest digital-first media companies, the former CFO of the Huffington Post (News - Alert), and most recently President of DTC apparel brand M.M.LaFleur.
Eric Ashman recently launched a management consulting firm, focused on helping venture-backed founders navigate the challenges of growth during uncertain times.
The following are excerpts from that conversation. The comments and quotations been edited for content and clarity.
Definition of Contribution Margin
If you want to measure the unit economics of each product that your business sells - and you should want to - you’ll need to know your contribution margins.
If you take the Net Unit Sales Price of an item and subtract the Unit Variable Costs incurred to create and sell a product, you have Contribution Margin.
When calculating the Net Unit Sales Price for this equation, make sure that you take into account any promotional or discount pricing that you’re using in order to sustain your current sales level. As you lean more heavily on promotions and discounts, the Net Unit Sales Price will decrease, and your calculation should reflect this change.
Calculating the Unit Variable Costs for this equation can be a bit more complicated. Unit Variable Costs refer specifically to the production and sale of one unit of product or service. Differentiating between variable and fixed costs is where the most errors occur in this equation.
Variable Costs include:
- Direct Labor
- Completed Goods
- Raw Materials
- Inbound/Outbound Logistics
- Merchant Fees
- Sales Commissions
- Processing of Returns
Fixed Costs include:
- Equipment Leases
- Management Salaries
- Utility Costs
- Indirect Labor
- Marketing Expenses
Costs that may be classified differently at different companies include:
- Customer Service
- Direct Labor (in some cases)
- Variable Technology
- Fluctuating Expenses Based on Sales Volume
Step 1: Start Calculating
Your first step should be to calculate the contribution margin of every product or service you that you offer.
If you have a lot of different offerings for sale, a simple bar chart can create a visual reference that makes it easier for you to see the contribution margin across your entire product line. If you add a line to indicate sales volume for each product, you now have enough information in front of you to start making decisions.
Step 2: How to Increase Contribution Margins
Once you know your contribution margin for each product, you can make decisions that influence your profitability and cash flow, such as raising prices and reducing discounts.
There’s no denying that the costs of doing business have gone up across the board; to attempt to keep your pricing the same is a recipe for disaster. Keeping prices the same indicates that you are chasing growth at the expense of every other indication of success. It is not sustainable.
The simple fact is that as your costs increase if you don’t raise prices, your margins will fall, and your cash flow will suffer.
You can start by raising prices on your most popular products, focusing on bringing your contribution margins back to your original targets.
Your second step will be minimizing Variable Costs, where you can. This may not result in the significant savings that you’re hoping for, but there are several areas you may have success in:
- Change the packaging of your products to a less expensive option.
- Cut shipping costs by changing from air to sea.
- Raise the order threshold for customers to earn free shipping.
- Consider charging a restocking fee on returns.
It may also be time to consider more long-term cost savings strategies, such as:
- Renegotiate rates with suppliers.
- Shop around for a new Third Party Logistics supplier.
- Automate where you can to minimize labor costs.
- Explore lower-cost raw materials that you can substitute for in your products.
Pursue both long- and short-term solutions.
Raising prices allows you to refocus your organization on your highest contribution margin products. Your marketing, product development, and customer experience budgets should all be targeted toward the selling of these items. As you increase volume in your most profitable products, you’ll improve overall profitability and cash flow.
Step 3: Eliminate Negative Contribution Margin Products
You must let go of negative contribution margin products; each sale is literally costing you money and wasting resources. Gross sales are tempting to use as a metric, but the reality is that it’s not an indication of profitability, which matters more now than ever.
Your low contribution margin products will require further analysis. Some of these will be retained because they require little to no marketing and development investment in order to generate a profit. You might discover a few cash cows here that will keep generating meaningful cash flow with very little effort. However, some low contribution margin products will have to be let go if they’re using valuable resources in order to generate sales.
Let the numbers speak for themselves and make decisions quickly. Holding on to gross sales over gross margins will only prolong the pain you’re feeling now.