Understanding Contribution Margins

Gone are the days of growth at any cost, when investors eagerly funded unprofitable but expanding DTC brands. Today, the focus has shifted to profitability and sustainable growth. At first glance, profitability may seem simple: revenues minus costs - but as always, it's not that straightforward!

One of the key metrics used to measure profitability is Contribution Margin (CM). Because Contribution Margin is such an important metric, and because achieving a positive CM is the primary goal for many brands, it is often broken down into sub-metrics to show how close a business is to profitability and how much money is left to cover the next block of costs. The most common breakdown is CM1 through CM3:

• CM1: After COGS
• CM2: After Operations
• CM3: After Marketing

This article will help you understand the different levels of contribution margin - CM1, CM2, and CM3.

What Are Contribution Margins?

Contribution Margins are a measurement of how much revenue is left after covering specific costs, which can then help cover fixed costs and generate profit. By analyzing these margins, you can evaluate the profitability of your product at various stages.

Contribution Margin 1

Contribution Margin 1 (CM1) represents the net revenue remaining after deducting the variable costs directly associated with producing the goods sold. It is an indicator of your core product margin.

Your CM1 is calculated by taking:

Contribution Margin 1 = Net Revenue - COGS

You can increase CM1 by:

• Improving all metrics that affect net revenue, such as product returns and AOV. Therefore, CM1 is the most important metric related to customer behavior.
• Raising prices
• Reducing discounts
• Lowering production costs
• Changing the mix of products purchased to higher-margin products

Contribution Margin 2

Contribution Margin 2 (CM2) is what's left after all the costs associated with fulfilling the order have been accounted for (think of it as all costs except marketing). It gives a clearer picture of profitability after production-related fixed costs are taken into account.

Contribution Margin 2 = Contribution Margin 1 - Fulfillment Costs

CM2 can be optimized independently of customer behavior, typically through economies of scale or increased volume. More orders lead to better terms and improved processes. Unit costs should fall steadily; if they don't, something is wrong with your operations.

To increase CM2, you can reduce fulfillment costs by:

• Optimizing logistics
• Negotiating better shipping rates
• Lower packaging costs by finding cost-effective solutions
• Economies of scale

Contribution Margin 3

Contribution Margin 3 (CM3) includes your marketing expenses. Essentially, it's the money left over to pay salaries, office expenses, etc. Whatever is left after your overhead is your profit.

Contribution Margin 3 = Contribution Margin 2 - Marketing Spend

Please note that customer acquisition cost (CAC) cannot be broken down on an individual customer basis. CAC is always an average. Once you acquire more than one customer, it's impossible to determine the exact cost of acquiring each one. For example, if you have two customers - one who spent $10,000 and another who spent $10 - and your CAC is $4,000 and you can assume that marketing probably paid off overall, but you can't determine the acquisition cost for each customer individually.

You can improve CM3 by:

• Increasing conversion rates
• Increasing AOV
• Increasing share of repeat purchases
• Focusing on high-performing campaigns
• Improving efficiency by allocating your budget towards the most cost-effective channels

What is a Good Contribution Margin 1

Every D2C brand should strive for strong contribution margins. But what constitutes a "good" contribution margin can vary from industry to industry. So let's put your CM1 into perspective and compare it to industry benchmarks using average CMs  of DTC brands:

• Apparel & Fashion: 60%+
• Beauty & Cosmetics: 70%+
• Food & Beverage: 40%+
• Supplements: 50%+
• Home & Living: 40%+

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