March 29, 2024

How to Calculate Ecommerce Product Margins: Gross Profit and Contribution Margins

Gurman Sihota

Direct-to-Consumer (DTC) ecommerce brands must master the science of generating positive returns on investments for both product and marketing. Businesses that struggle with one or both spend categories find it hard to scale sustainably and reach profitability.

DTC ecommerce businesses face the challenge of offering a value proposition to customers that entices them, while spending wisely on advertising, product, and everything else required to run a company. Investment in product, marketing, and operations must generate sufficient return on investment (ROI) to justify the spend.  

Ecommerce businesses thus need to pay close attention to all business costs when determining product margins. To ensure investment in the right place and to track ROI, it’s important to calculate (and project) both gross profit margins and contribution margins.

What is a Gross Profit Margin

Gross profit margin is the difference between revenue and cost of goods sold, divided by revenue. Gross profit margin is expressed as a percentage. Gross profit is simply gross profit margin but expressed in dollars, i.e., revenues less the cost of goods sold. Generally, gross profit margin is calculated as the revenues of a business, less the cost of goods sold, then divided by the same revenues.

Gross Profit Margin for Ecommerce: The Baseline Profitability Metric

For a DTC ecommerce business, gross profit margins are core to ensuring adequate returns are being generated on the products the business sells. In its simplest form, gross profit margin tells businesses the excess return they generate from selling a product relative to the cost to procure or produce the product. These margins can vary, but the average DTC brand at Clearco has gross profit margins in the range of 40% - 70%.

Gross profit margins do not account for the costs required when:

  • Acquiring the customer (i.e., marketing or sales)
  • Delivering the product to the customer (i.e., last mile delivery or freight)
  • The costs associated with storing the product and accepting returns (i.e., refrigeration or return logistics)

While gross profit margin is a critical metric to track, business owners must understand it can overstate the financial health of a business by excluding shipping and marketing costs. For that reason, Clearco focuses on the delivered gross margin which is most commonly known as contribution margin.

What is Contribution Margin or Delivered Gross Margin?

Contribution margin, or dollar contribution per unit, is the selling price per unit minus the variable costs per unit. "Contribution" represents the portion of sales revenue that is not consumed by variable costs and so contributes to the coverage of fixed costs. Conversely, gross profit margin focuses exclusively on the cost of goods sold, and does not include other variable costs.

The Importance of Contribution Margin for Ecommerce

Contribution margin allows for a more accurate and holistic picture of a business’s performance by including expenses such as shipping and marketing, which gross profit margin does not.

Free shipping has been a massive source of customer satisfaction for Amazon and has forced smaller ecommerce brands selling outside of the Amazon ecosystem to offer free shipping. Approximately three-quarters of the top 1,000 ecommerce retailers in the United States (U.S.) offer free shipping on at least some orders, with 45% requiring a minimum purchase for the customer to obtain free shipping. Smaller brands do not benefit from the same scale advantages Amazon does, which makes their per unit shipping costs meaningfully higher than Amazon. Within the Clearco ecommerce ecosystem, shipping costs are the second or third largest operating expense item.

Equally important is tracking marketing spend, which gross profit margins exclude; ecommerce brands often rely on Google and Meta advertising to acquire customers, and costs can creep up, especially during high-consumption periods such as Memorial Day and Black Friday Cyber Monday (BFCM). For instance, advertising on platforms like Amazon saw a 30% increase over holiday seasons, with costs rising from $0.93 to $1.20 per click.

Marketing costs have also increased over time for all DTC ecommerce companies due to iOS privacy changes requiring users to provide explicit consent for apps to collect and share data as well as the removal of lookalike audience marketing from Google Ads. Amid that initial shift, the average cost of sales conversions for e-commerce marketers surged 200% for tracked users and 155% for non-tracked users during the six-month period.

How to Calculate Contribution Margin

If the core business of a company is producing merchandise, selling it to a consumer, and then getting that product to their front door, there should be no mystery around the economics of that transaction. Contribution margin ensures there is no mystery about how much money the business has to invest in other activities after covering all the necessary expenses to sell their product.

Contribution Margin =

Net Sales - (Cost of Goods Sold + Shipping Expense + Marketing Expense) / Net Sales

What Contribution Margin Can Tell You

The benefits of tracking contribution margin include identifying:

  1. If Your Product Pricing Is Too Low
    Pricing strategy is critical to the success of any e-commerce business, and founders may unintentionally underprice their product by ignoring marketing and shipping costs.
  2. If Your Cost of Acquiring a Customer Is Too High Relative to Gross Profit Margin
    If gross profit margins are healthy but marketing spend is high, this may indicate your product is struggling to find its end-market.
  3. If You Can Afford to Provide Free Shipping or Need to Increase Your Free Shipping Threshold
    While free shipping is a powerful tool to generate sales, smaller DTC e-commerce businesses without significant scale to offset the cost of shipping may need to increase their free shipping thresholds.

Calculating Contribution Margin Empowers Ecommerce Companies to Operate Efficiently

Successful ecommerce businesses have a product that fills a need for customers, and can sell that product profitability to support continued growth and reinvestment. While gross profit margin analysis provides a great base, contribution margin is a powerful and simple metric that can provide founders with increased visibility into their business.

Gurman Sihota
Strategic Finance Associate, Clearco

Gurman Sihota is a Strategic Finance Associate at Clearco. Prior to Clearco, Gurman was an Investment Banking Associate at Scotiabank. A University of British Columbia (UBC) graduate, he pursued a Bachelor of Commerce, specializing in Finance. When he isn’t busy diving deep into the DTC ecommerce space, Gurman enjoys trying to learn how to hit a golf ball and trying new fitness classes.