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Demand & Inventory Planning

Understanding Contribution Margin (Don’t Sell Yourself Out of Business)

Demand & Inventory Planning
June 30, 2021
12 min read
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Having the discipline to factor in every cost that affects your overall contribution margin allows you to see the true profitability of your sales at the sku level. Merchants who achieve this level of control over their profitability can take their business wherever they want it to go. Ware2Go’s Entrepreneur in Residence, Jack Kiefer, dives into the data sets you may be missing to gain this kind of control.

What Does It Mean to Sell Yourself Out of Business?

Understanding Contribution Margin: You Don’t Have to Keep Driving on Ice

I’ve devoted my career to working with entrepreneurs because I am one. I understand the passion for a product and its place in a particular industry that drives small to mid-sized merchants. While this passion is what makes a memorable and attractive brand, it can unfortunately also be the thing that takes your business over the cliff. Hyper-focus on product quality, sales, and brand can sometimes cloud your vision and make you miss data that’s integral to the very foundations of your business. That’s why I’ve dedicated myself to helping entrepreneurs avoid obvious pitfalls and ensure the longevity of their business.

Between the rapid growth of ecommerce and low barriers of entry for digital sales channels, some merchants are at the crest of a wave without any real understanding of what’s holding them up. Launching multiple online channels and funneling in buyers has never been easier, but if merchants aren’t careful they could easily sell themselves out of business. You could potentially coast on high volume, low profitability sales for 2-3 quarters without realizing the wheels have fallen off, but soon you’ll start to see a bottleneck in your cash flow. You’ll start negotiating for more flexible payment terms with your vendors and worrying about making payroll each month, and you’ll wonder why because your sales are through the roof.

For most SMB’s their first instinct is to simply sell more — increase that top-line revenue. But the truth is, you will never be able to out-sell your Cost of Goods Sold (COGS)*. It will eventually catch up with you, and the only way to have confidence in your business model is to take a good hard look at the line item profitability of each and every one of your sales. You may think, “Well, I’m already looking at my Brand and Category Sales Reports and my ROAS Report,” but these high-level reports hide nuances and nuggets of opportunity to maximize your profits.

Most retail reporting shows Brand or Category Level profitability, leaving out important factors like sales channel marketing, Freight in/out, or returns. That’s why it’s so important to move beyond basic high level retail reporting and incorporate every factor that affects your Net Contribution Margin — even those that your ecommerce shopping cart isn’t tracking. When you assess all of these factors together, you’ll learn which sales channels are most profitable that you should therefore be routing more inventory to. You’ll see where, geographically, your sales are coming from and where you should be stocking inventory to lower your cost to serve. You’ll even begin to properly rationalize your SKU assortment when you find the SKU’s that are pulling down your overall margins. When I finally had the discipline to examine my business’s profitability at this level, I no longer felt like I was driving on ice. I finally felt like I was in full control of my business, and that was a great feeling.

The Problem With Success

I can’t emphasize enough how easy it can be to get lulled into a false sense of security by high-level, broad-brush-strokes kinds of reporting. That’s because selling yourself out of business isn’t a concern for companies with stagnant sales. This is a problem unique to successful, fast-growing companies.

Take my business for example. When we jumped from $35 million to $50 million in sales, it was due in large part to a smaller assortment of competitively priced, high volume products. When we saw how fast those items were selling, we ordered more just to keep up with demand. However, when the dust settled and we were able to take a good, hard look at what we thought were our big “money-makers,” we found that after freight, returns, and customer acquisition, we were making razor thin margins on those sales. In fact, if we had experienced a slightly higher rate of return, or a slightly lower conversion rate on those products, we could have even lost money.

It’s not lost on me that transaction-level analysis requires resources and capabilities that most SMB’s don’t readily have on-hand. In the past, you would have needed an in-house data analyst, a database administrator, a full stack developer to move and integrate data from multiple sources — aggregating it into a data warehouse while maintaining the state of all of your systems and data, and then displaying all that data in a visualization or reporting system.

This all may seem daunting, but thanks to new Saas advancements in backend reporting and analytics, insights that were previously available only to enterprises are seemingly more readily accessible to businesses of all sizes. These advancements have opened up access to this data without even increasing headcount. However, there’s a key piece of data that’s likely missing from your current reporting.

Measuring Your Contribution Margin Is Within Reach

The data you’re missing may come from an unexpected source: your logistics provider. The logistics industry is changing. It’s no longer made up of a bunch of luddites moving your stuff from one place to the next. The industry is evolving to be more reliant on technology in order to keep up with ever-evolving digital sales channels. The data that is the missing link to getting a real look at your profitability is in your warehousing costs, your inventory carry costs, and your shipping and freight costs. The secret to digging into your profitability, however, is in aggregating data collected on the logistics side (via your OMS, WMS, and TMS) with data you’re already accessing on the sales side (via your CRM and online shopping cart).

New Saas developments in logistics tech not only make this missing link in your data available, but can aggregate the data from all sources to a single intuitive platform. This is a game-changer for SMB’s, giving businesses of any size the keys to unlock enterprise level insights. Unlocking this data will allow you to make strategic decisions about your supply chain to lower your COGS and ultimately improve your profitability. Once you gain full control of your COGS you’ll start to see:

  • Inventory in the right place at the right time
    • No more long-zone shipments or costly overnight air to maintain marketplace SLA’s
    • No more costly stock outs or inventory obsolescence
  • Profitability across all sales channels
    • No more lost margins in the battle for the Buy Box
    • No more lost sales from feeding inventory to the wrong channels
  • Lower Customer Acquisition Costs
    • No more overpaying for Cost per Click (CPC) ads in locations with poor conversion rates
    • No more lost customers due to poor service levels

Measuring the Key Three

You’ll also start measuring the 3 main drivers of your sales and balancing them for maximum profitability. I call them The Key 3:

  • Price – Is your price low enough to win the Buy Box, but high enough to maintain your profitability goals?
  • Discoverability – Is your SEO and digital advertising optimized so high-intent shoppers are actually finding you in search or marketplaces?
  • Content  – Are your product photos/videos and descriptions eye-catching and accurate while capturing the proper converting keywords? Do you have enough excellent reviews across all platforms?

None of The Key 3 exists in a vacuum. Each affects the other, and together they have a major impact on your bottom line. For example:

  • You’re being priced out by a competitor, so you lower your price but don’t run a digital ad campaign, so your product isn’t discoverable. You can lower your prices all day, but if no one sees your listing, you’re not making any sales.
  • You’re highly discoverable but have bad reviews, causing shoppers to scroll right past your listing to a more trusted vendor.
  • The only lever you’re pulling is pricing, constantly repricing to have the lowest price listing and eating up your margins.
  • You try to fix your discoverability problem with an expensive digital ad campaign, losing even more margin.

This balancing act is, again, a problem specific to fast-growing businesses. You can ignore this process when you are small and your marketing spend is limited, but ignoring it for too long may materially impact your bottom line and affect your ability to finance your business. Lack of discipline to measure and adjust the Key 3 results in:

  • Overstocked inventory
  • Loss of sales due to out-of-stocks
  • Losing money on overnight air just to keep your Prime status
  • Missing customer expectations and racking up bad reviews
  • Dropping your prices below profitability to make more sales
  • Investing good money after bad inventory
  • Having inventory in the wrong location

The solution, again, is not more sales. The solution is having the discipline to examine each and every factor affecting your Net Contribution Margin* for each and every transaction. This data is dynamic, and you may find that to really maintain control of your profitability, you’re making adjustments to your business on a daily basis.  At this point when you feel confident, it may even be time to dust off an old  statistical analysis text book and re-learn reporting while utilizing tools like Mean, Mode, Median, and Standard Deviation.

The Result: Longevity, Security, Foresight

The result of implementing this level of reporting discipline will ultimately contribute to the longevity and profitability of your business. You’ll have your finger on the pulse of your profitability, and your profits will be driven by things like having your inventory in the right place at the right time. This seems like such a simple idea, but its value really can’t be overstated. I once saved a client $4 million in freight cost by relocating a single brand to a facility closer to their largest pocket of demand. You’ll also have complete confidence in your price adjustments. Automatic repricing features can be a blessing and a curse, and if you’re not careful you could easily sell through hundreds of thousands of dollars of losses if your price is too low. Rather than leaving your pricing strategy fully in the hands of machine learning, new Saas features can alert you when a price change is outside of standard deviation and may need a deeper dive and a human touch.

You’ll also have the security to rest easy at night, knowing that you have the full picture of your Net Contribution Margin. You will no longer be taking shots in the dark when it comes to pricing, stocking inventory, or launching a new sales channel, and you’ll no longer have your capital tied up in bad inventory or inefficient supply chain functions.

And finally, you’ll gain foresight. With statistical analysis you can forecast the potential revenue increase of your growth levers and really go after major change agents full force to make the most impact on your business. Additionally, your freed up capital will allow you to actually invest in your future growth.

Taking the Wheel

The process of implementing these digital enhancements to your Supply Chain management relies heavily on AI that learns the rhythms and cycles of your unique business. At Ware2Go, we analyze at least 3 months of historical data, either data brought in by the client from past sales or monitored through 3 months worth of shipping patterns after onboarding. The algorithm can also be adjusted for expected shifts in demand like seasonal spikes or promotions, and the longer these patterns are monitored, the more accurate the projections will become.

If you’re ready to take a deep dive into your data, schedule a time to talk to one of our supply chain experts.

*A Note on Terms:

  • Net Contribution Margin: This is a hotly debated term with several accepted formulas. In my businesses and for the purpose of this piece, I’ve always calculated Contribution Margin as Net COGS (including freight) + Marketing Costs + (If an above average rate was observed) Rate of Returns
  • COGS (Cost of Goods Sold): In traditional manufacturing, COGS is calculated as raw materials and manufacturing costs. For these purposes, we’ll include the cost of freight in.

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