Contribution Margin is King
In the go-go fundraising markets since the last financial crisis, we’ve lived in a world where revenue is king. Cash can be burned in pursuit of topline growth, without too much regard to the bottom line.
However, recent changes in the fundraising market (global pandemic? high profile over-capitalized company explosions?) have finally started to shift this perception. Maybe every incremental revenue dollar isn’t all we should care about? Selling $1 for $0.80 might not be the most rational thing to do?
We’ve finally entered a world where people have begun to think not just about revenue growth, but also gross margins (GM) — how many dollars you keep of your revenue after subtracting your cost of goods sold. The market has come to appreciate that it’s not just the dollars you’re adding to your topline, but how many of those cents you’re dropping below the gross profit line to offset fixed costs.
I would argue, however, that we haven’t gone far enough. It’s not just about gross margins — contribution margin (CM) should be our focus.
Contribution margin is equal to gross margin less any other variable costs, in particular any costs associated with customer acquisition:
Contribution Margin = Revenue — COGS — Customer Acquisition Cost
This last piece is incredibly important, particularly for B2C businesses. You might have a product selling like hot cakes at 60% all-in margins and think you’re doing great. However, you also might be missing the incredibly important detail of how many dollars you’re really dropping to the bottom line after paying Facebook for that customer. We’ve seen too many businesses lose sight of this and end up overspending on customer acquisition.
Contribution margin is so important because it’s the actual dollars you’re dropping to offset your fixed costs (payroll, rent, legal fees, accounting, etc.). With CM, you can begin to think of your product in terms of the number of units you need to sell to breakeven. CM allows you to never lose sight of the fact that you need to make more gross margin than CAC or you’re sprinting out of business.
When you think about everything in terms of CM, it pretty quickly boils the business down to two simple equations:
Revenue required to breakeven = Fixed Costs / % Contribution Margin
Or on a per unit basis:
Units required to breakeven = Fixed Costs / (AOV x % Contribution Margin)
That’s it. The question is no longer whether the business is working, but instead the next-order question of how can you optimize CM so that you can sell the fewest possible products to pay off your fixed costs. Or, if you have a low CM product, knowing what velocity you need to sell in order to achieve breakeven.
There’s no precise science of the “perfect” CM. We generally like companies that have double-digit dollar CM — this takes pressure off the topline to sell such a large volume that low CM units can offset all costs. However, there are several correlated items — repeat (or subscription) rates, product durability, frequency of purchase by category, etc. that make it hard to draw a hard-and-fast line.
Of course net income margin matters as well — more on that in a future post. There are a different set of considerations to think about when it comes to your fixed cost base. However, when considering variable, contribution margin gets you a lot closer.
The answer of the exact right CM is a calculation each startup must make. But once you reorient your view on unit economics to focus on this atomic unit rather than just revenue or gross margin, you will be a big step closer to achieving capital efficient growth.
