Definition: Contribution profit is the total amount of money that remains after subtracting all variable costs from sales. It is similar to the contribution margin but is usually looked at in total rather than per unit. Contribution profit helps a business understand how much money is available after covering the costs directly tied to producing and selling its products, which can then be used to pay for fixed costs and generate a profit.
How to Calculate Contribution Profit
Contribution profit is calculated by subtracting the total variable costs from the total sales revenue. Here’s the formula:
Contribution Profit = Total Sales Revenue − Total Variable Costs
Unlike contribution margin, which is usually calculated per unit, contribution profit is the total for all units sold.
Example 1: Small Bakery
Imagine you run a small bakery that sells cupcakes. Each cupcake sells for $3. The variable costs for each cupcake include:
- Ingredients (flour, sugar, eggs, butter): $1
- Packaging (cupcake box and wrapper): $0.30
So, the total variable cost per cupcake is $1.30.
Now, to find the Contribution Profit per cupcake: 3− 1.30 = 1.70
This means each cupcake sold brings in $1.70 after covering the cost of ingredients and packaging. This money can then be used to pay for fixed costs like rent, electricity, and the baker’s salary, and also contribute to the bakery’s profit.
If a product has a high contribution profit, it means the product is more profitable. Companies use this information to decide which products to focus on.
Example 2: Clothing Store
Imagine you own a small clothing store that sells t-shirts and jeans. Let’s say each t-shirt sells for $20 and each pair of jeans sells for $50. The variable costs for the t-shirt are $8 (for materials and labor), and the variable costs for the jeans are $30.
To find the Contribution Profit for each item:
- The T-shirt Contribution Profit is 20 − 8 = 12.
Each t-shirt brings in $12 after covering the costs for materials and labor. - The Jeans Contribution Profit is 50−30 = 20
Each pair of jeans brings in $20 after covering the costs for materials and labor.
Now, if the store has fixed costs (like rent and salaries) of $2,000 per month, they would need to sell enough t-shirts and jeans to cover those costs. Knowing the contribution profit helps the store figure out how many t-shirts and jeans they need to sell to break even or make a profit.
Why Contribution Profit Matters
Contribution profit gives businesses a big-picture view of their profitability. It shows how much money is available after covering the costs that vary with production levels. This metric is useful for making decisions about product lines, pricing strategies, and sales tactics.
For example, if a company finds that its contribution profit is low, it might look for ways to reduce variable costs, like finding cheaper suppliers or improving production efficiency. Alternatively, it might decide to increase prices if customers are willing to pay more.
Understanding Contribution Profit helps in making strategic decisions:
- Pricing: Adjusting prices can impact both sales volume and contribution profit. If raising prices doesn’t reduce sales significantly, it can increase overall profits.
- Cost Control: Reducing variable costs can increase contribution profit. This might involve negotiating better prices with suppliers or finding more efficient ways to produce products.
- Product Focus: Companies might focus on products with higher contribution profits and reduce or eliminate those with lower profits. This ensures they are focusing on their most profitable items.
Example from a Leading Brand
Lululemon, a popular athletic wear brand, might use contribution profit to decide which clothing lines to expand. If they find that the contribution profit from yoga pants is higher than that from sports bras, they might decide to introduce more styles or colors of yoga pants.
Shortcomings of only focusing on contribution profit
While contribution profit is a useful metric, it is not without its challenges. Some businesses may struggle with accurately calculating their variable costs, especially if these costs fluctuate frequently. Additionally, focusing too much on contribution profit can lead businesses to overlook other important factors, such as customer satisfaction and long-term growth.
Contribution Profit in D2C Marketing
Contribution profit is not just useful for understanding which products are most profitable; it’s also a powerful tool for calculating the efficiency of ad spend. Direct-to-Consumer (D2C) brands and other companies use this metric to decide how much money they should spend on advertising and where they should spend it. This helps them get the most out of their advertising budget and grow their businesses in a cost-effective way. Let’s explore how this works.
What is Contribution Profit?
To recap, contribution profit is the money left over after subtracting the variable costs of producing a product from the revenue generated by selling that product. It shows how much each product contributes to covering fixed costs and generating profit. Knowing this helps companies decide which products to promote and sell.
Why Use Contribution Profit for Ad Spend?
When it comes to online advertising, brands want to know if their ads are making them money. Just looking at how many clicks or views an ad gets isn’t enough; what matters is how much profit those clicks bring in. By using contribution profit, brands can calculate how effective their ads are at generating real profit, not just sales.
Here’s why this is important:
- Calculates True Return on Investment (ROI): Contribution profit helps brands calculate the true ROI of their ad campaigns by considering not just revenue but also the cost of goods sold. This gives a clearer picture of whether the money spent on ads is actually generating profit.
- Optimizes Ad Spend: By understanding which products have the highest contribution profit, brands can focus their ad spend on promoting these products. This ensures that every dollar spent on advertising is more likely to result in profitable sales.
- Improves Budget Allocation: Contribution profit helps brands allocate their budget more effectively across different ad channels and campaigns. They can invest more in channels that bring higher contribution profits and less in those that do not.
How Brands Use Contribution Profit to Measure Ad Efficiency
Here are some ways D2C and other brands use contribution profit to measure the efficiency of their ad spend:
1. Measuring Cost Per Acquisition (CPA)
Cost Per Acquisition (CPA) is how much it costs a brand to acquire a customer through advertising. By comparing CPA with contribution profit, brands can see if they are spending too much to gain each customer.
- Example: If a company spends $10 on ads to sell a product that has a contribution profit of $15, their net profit per sale is $5. However, if their CPA rises to $15, they would be breaking even, and anything higher would result in a loss. Brands constantly monitor CPA to ensure it stays lower than their contribution profit.
2. Analyzing Customer Lifetime Value (CLV)
Customer Lifetime Value (CLV) is the total profit a brand expects to make from a customer over their entire relationship. Brands use contribution profit to understand CLV better. If they know the average contribution profit from a sale, they can estimate how much a customer is worth over time.
- Example: A beauty brand might find that its average customer makes four purchases a year, with an average contribution profit of $20 per purchase. If customers typically stay loyal for two years, the CLV or customer lifetime value is $160. This helps Glossier decide how much to spend on ads to acquire new customers.
3. Improving Ad Targeting and Content
Brands use contribution profit data to see which products are most profitable and then tailor their ads to feature these products. They can also analyze which types of customers buy these high-profit products and target their ads more precisely to similar audiences.
- Example: A clothing brand could find that its most profitable customers are young professionals buying premium jeans. They might then focus their ad campaigns on platforms like Instagram and LinkedIn, targeting this demographic with ads for their premium jeans.
How to Optimize Advertising Based on Contribution Profit
To get the most from their ad spend, brands need to optimize their advertising based on contribution profit. Here’s how they do it:
1. Focus on High-Profit Products
Brands often choose to promote products with the highest contribution profit. This means putting more ad dollars behind products that bring in the most profit, ensuring a higher return on investment.
- Example: An athletic wear company like Nike might promote its high-profit sneakers over low-margin items like socks. Even if the socks sell well, the lower profit margin means they are not as effective for ad spend.
2. Segment Customers Based on Profitability
Brands can use data to segment customers based on how profitable they are. This allows them to target ads more effectively, focusing on acquiring and retaining the most profitable customers.
- Example: A D2C coffee brand might find that subscribers who buy coffee beans every month are more profitable than one-time buyers. They could then create targeted ads and promotions for new subscribers, offering discounts on the first subscription month.
3. Test and Adjust Ad Campaigns Regularly
Brands should constantly test their ad campaigns to see which ones bring the most contribution profit. This means trying out different ads, channels, and strategies to find the best combination.
- Example: A skincare brand could run multiple ad campaigns on Facebook, Instagram, and Google. By tracking the contribution profit from each campaign, they could shift more of their budget to the platform and ad type that generates the highest profit.
