Don't blindly chase revenue: Why contribution margin matters more

Don't blindly chase revenue

In the early 2020s, a flood of venture capital money entered the Direct to Consumer space. Brands like Warby Parker, Allbirds, Rent the Runway and Casper immediately come to mind.

It prompted a "growth at all costs" frenzy across the industry. Much of this venture cash went into paid ads and inventory, with the aim of growing top-line revenue as quickly as possible and reaching the huge scale that the venture-backed model demands. Founders made a bet that they'd recoup short-term losses over the lifetime of a customer. And VCs weighed in on this bet by investing over $5 billion at the peak in 2021.

Total VC investment into eCommerce ($USD B)

Many DTC businesses have faltered since, not because of the channel itself, but because they lost sight of this business fundamental: you can't pay more to acquire a customer than they are worth to your company. In the pursuit of revenue, brands overspent on acquisition costs and lost their focus on profitability. They were ill-disciplined. The post-pandemic period proved to be tough for many brands, and VC interest waned too, with just $140m invested in 2023 - a 97% drop from the peak.

At Wayflyer, we've had the privilege of partnering with thousands of consumer brands as they've navigated these ebbs and flows in the market. The characteristics of those who've come out the other side stronger are glaringly obvious. It's a combination of profitable unit economics and careful cash flow management that makes a good business. The best operators obsess over this fact.

We remain steadfast in our commitment to give the world access to the best products by empowering great brands to reach their growth potential. Our financing product has been doing this since our inception. But given our unique access to rich industry data, we feel a duty to go one step further and provide guidance on what "healthy" financial performance looks like.

This is the first of a series of articles to do just that, starting with arguably our most important piece of advice: Don't blindly chase revenue. Obsess over contribution margin instead.

Obsess over contribution margin instead

If you are to obsess over a single metric that reflects the health of your business, it should be contribution margin. Understanding it is a non-negotiable for eCommerce operators, because it's the fuel that drives your ability to turn a profit. Mathematically, it's a straight-forward equation:

contribution margin = net selling price - variable costs to deliver each sale

Your contribution margin reflects how much each additional sale, after deducting the associated variable costs, "contributes" to turning a profit. You should be aiming to cover your fixed operating expenses at a minimum, and then any additional earnings can flow into the profit bucket.

Understand the components of contribution margin

The equation above is straight-forward, but to properly grasp each component of contribution margin, let's walk through a simple example. It's important to understand any nuance that exists within each line item, because these are the levers you tweak to improve the profitability of your business.

Let's start with sales

It's important to be very clear on what sales figure is included in the contribution margin calculation. It's "net sales", which is different to the "total sales" figure you see in your store dashboard because it strips out taxes and any shipping charges paid by the customer.

total sales = order revenue - discounts - returns + taxes + shipping charge

net sales = total sales - taxes - shipping charges

Now consider the variable costs

Think about the costs required to get your product from the manufacturer into the hands of an eager customer:

• Product cost: the cost of manufacturing and packaging each product, also commonly referred to as the "cost of goods sold"
• Freight cost: the cost of getting the product from the manufacturer into your warehouse or fulfilment center
• Fulfilment cost: the cost of picking, packing and delivering the product to your customer
• Transaction fees: any merchant or payment processing fees incurred per transaction

If you subtract these costs from the net sales, you arrive at a figure for gross profit.

Factor in ad spend to get your contribution margin

You need a customer on the other side of each sale and, unless you're lucky enough to become a word-of-mouth viral success, there's usually a cost to acquiring them. This line item should only reflect direct response performance marketing spend, ignoring fixed fees like agency costs or brand campaigns, which go into OpEx. Subtract an estimate for ad spend per sale from your gross profit to arrive at that all-important contribution margin figure.

Aim to cover your fixed operating costs, then generate a profit

Contribution margin is the total dollars generated before fixed expenses like payroll, rent and utilities. The goal should be to earn enough to cover these fixed operating expenses at a minimum. Anything beyond that is profit. Keeping your OpEx lean and avoiding any headcount bloat is a huge advantage in the pursuit of profitability, as we've outlined in more detail here.

If you're not yet earning enough contribution margin to cover your fixed operating expenses, does that make you a bad business? Not necessarily, but that should be your goal at scale. For instance, if you're a business in its early days, you might've established a strong contribution margin per unit, but aren't yet selling at a volume that exceeds your break-even point in units. To solidify yourself as a healthy business, you need to reach that point. External financing options like Wayflyer can help you get there.

Consider these real-world examples: a tale of two brands

Consider this tale of two brands: BizA and BizB. Both sell a similar product at the same price point of $100, but have very different contribution margins.

BizA sells more units than BizB and has a higher revenue figure as a result.

It even has a slightly better MER (Marketing Efficiency Ratio), meaning it's generating more sales per dollar of ad spend.

marketing efficiency ratio (MER) = sales / ad spend

If you were to consider units sold, revenue and marketing efficiency alone, you'd be forgiven for assuming BizA was the better performing business. But let's dig into the contribution margin that each business generates to see if the picture changes.

BizA source their product from a premium supplier, so their product costs are higher than BizB, despite selling at the same price point. BizA are poor at stock forecasting, so are frequently forced to turn to air freight for its quick delivery times, while BizB's shrewd inventory management means they can benefit from cheaper sea freight. BizA are inefficient with their fulfilment processes, frequently putting products in oversized packaging, while BizB have opted for a 3PL provider whose operations run like clockwork.

As a result, BizA have a much lower contribution margin per unit of $12, compared to BizB at $35.

Now let's look at the extent to which each business covers their fixed operating expenses. Assuming each business has the exact same fixed OpEx of $100,000, BizA need to sell many more units than BizB to break even.

break-even point = fixed operating costs / contribution margin per unit

They actually fall short of this and make a $40,000 loss. In comparison, BizB need to sell far less to break even, and have beaten this target to generate a profit of $40,000. Pulling contribution margin into this comparison paints a much different picture. The difference between the financial health of BizA and BizB is stark.

The best DTC businesses recognize how important the contribution margin metric is. True Classic, the golden child of eCommerce apparel and a Wayflyer customer, kept it top-of-mind on their journey to $200m+ in annual sales.

Calculate your own contribution margin

By this stage, it should be clear that keeping your contribution margin per sale top-of-mind is so important. You can make better pricing decisions, cut unnecessary costs, and know where your break-even point is.

Calculate your own contribution margin and break-even point below:

Caveat: It's important to note that this article has made several simplifications for clarity. Firstly, it considers only the first purchase and does not take lifetime value into account. In some cases, businesses with lower initial margins become highly profitable over the customer's lifetime through repeat purchases (e.g., a coffee subscription company). Secondly, it assumes the business sells a single product, whereas most businesses sell multiple products, each with slightly different contribution margin profiles. In practice, these nuances need to be considered.