How to Improve Contribution Margin

This post is the third in my series on Key Performance Indicators (KPIs), with a heavy emphasis on contribution margin (CM). Previously, I analyzed why CM is such a strong predictor of success. Given that, companies should consistently look at ways of improving it while still maintaining sufficient growth in their business.

In Azure’s recent full day marketing seminar for our consumer (B2C) focused companies, my session highlighted 6 methods of improving CM:

  1. Increase follow-on sales from existing customers
  2. Raise the average invoice value of the initial and subsequent sales to a customer
  3. Increase GM (Gross Margin) through price increases
  4. Increase GM by reducing cost of goods sold (COGs)
  5. Reduce Blended CAC (cost of customer acquisition) by increasing free or very low cost traffic
  6. Decrease marketing spend as a % of revenue

Before drilling down on each of these I want to define several key terms that will be used throughout the discussion:

  • Contribution Margin = GM – Marketing/Sales Costs – other cost that vary with sales
  • Paid CAC = Market Spend/New Customers acquired through this spend
  • Blended CAC = Market Spend/All new customers
  • CAC Recovery Time (CAC RT) = the number of months until variable profit on a customer equals CAC
  • LTV/CAC = Life Time Value (LTV) of a customer/CAC

I will now review each of these strategies and provide some thoughts on how to activate these in consumer-facing businesses:

1. Increase Follow-On sales from existing customers 

Since existing customers have little or no cost associated with getting them to buy, this will decrease blended CAC, increasing CM.

  • Increasing customer retention through improvements in customer care, more interesting and more targeted emails to a customer, or launching a subscription of one kind or another can all help.

On the first point here is an email I received shortly after subscribing to Harry’s, that I thought did an excellent job at engaging me with their customer support, increasing my likelihood to keep my subscription active:

Hi there,
My name is Katie, and I’m a member of the Harry’s team. I wanted to reach out and say thanks for supporting Harry’s.
You are important to us, and I am here to personally help you however I can to make your Harry’s experience as smooth as possible – both literally and figuratively. Please don’t hesitate to reach out with any thoughts or questions about your Harry’s products or Shave Plan, or just life in general. (And just a reminder that your next box is scheduled to ship on October 27th.) Thanks again for your support, and I hope to speak soon!
All the best,
Katie

On the subscription concept, think about Amazon Prime. How many of you buy more frequently from Amazon because of being a prime member?

  • Add to product portfolio. By giving your customers more options of what to buy (all within the concept of your brand) customers are given the opportunity to spend more often.
  • Make sure your emails are interesting. This will increase the open rate and drive more follow on sales. If all your emails are about discounting your product, then customers will have less interest in opening them and your brand will be devalued. I’ve received emails from numerous sites that say an X% discount is available until a certain date, and then when that date passes, I receive a new offer that is the same or sometimes better.  The most frequently opened emails have headers and content that creates interest beyond whatever products you sell. A/B test different headers and different content. It doesn’t matter how small or large you are or how many emails you send, it always pays to try different variations to increase open rates and conversion. Experiment with different messaging to different customer segments like those who purchased recently, those who “liked” an item, those that have never purchased, etc.
  • Build a Community of your customers. The more you can get customers engaged with you and with each other, the more committed to you they become and the longer they are retained. Think through how you can build an active community among your users through shared photos, videos, chatting, podcasts or events. Most of this should not involve trying to push new purchases but engaging your community to interact with you and each other.

2. Raise the average invoice value of the initial and subsequent sales to a customer

Since shipping costs will not increase proportionately, this will raise GM dollars and therefore CM.

  • Increase pricing. Most startups underprice their product thinking that will increase market adoption. Even some of the largest companies in the world have found there was ample room to increase prices. Thinking differently, Apple upped prices to over $1,000 for an iPhone. And then increased it again to $1,349 for the top of the line product. Five years ago, how many of you thought people would pay over $1,000 for a cell phone? This shows that unless you A/B test different price points you have no idea whether a price increase is the right strategy.
  • Upsell logical add-on products. While trying to get a customer to add to their shopping cart may seem obvious, many companies do not do this on a consistent basis. Some examples of ones that have: a flower company added vases to the offer, a mattress company added pillows and sheets; a subscription razor company added shaving gel; a cell phone company added a case. All of these led to reasonable attach rates of the add-on product and higher average invoice value. Testing what you could add to generate upsell should be a constant process.
  • “Selling” value added services is another form of upsell. This could include things like concierge customer service, service contacts, premier membership with benefits like: invites to special events, early access to new products, reduced shipping cost, preferred discounts on products, etc. If you get your customers to engage in one or more services, you will significantly increase their connection to your product and likely increase retention.

3. Increase Gross Margin through price Increases

Surprisingly, sometimes higher prices position a product as premium (having more value) and generate increased unit sales. Often higher prices generate more revenue even when fewer unit sales result. What may be counter intuitive is that GM$ can increase even if revenue declines. For example, suppose a company has COGs of $50 for a product and is currently pricing it at $100. If a price increase of 20% causes 20% lower unit sales, revenue would decline by 4% while GM$ would increase 12%. Higher gross margin dollars provide more ability to spend on marketing.

 

4. Improving GM by reducing COGs

  • Better Pricing: When your volume increases, ask for better pricing from suppliers. Just as its important to price test regularly, its also important to talk to multiple potential suppliers of your parts/product. An existing supplier may not be eager to voluntarily offer a price discount that goes with increased volume but is more likely to do so if it knows you are checking with others.
  • Changing Packaging: Packaging should be re-examined regularly as improvements may help customer retention. But it also may be possible to lower the cost of the packaging or to change it in a way that lowers shipping costs since that may be based on the size of the box rather than weight.
  • Shipping Costs: Lower shipping cost per $ of revenue (increasing GM and CM) by generating larger orders. In addition to upsell, this can be done by offering better discounts if the order size is larger. One site I have purchased from offers 10% discount if your net spend (after discount) is over $100, 15% if over $150 and 20% if over $200. Getting to the highest discount lowers the price of the product by enough to motivate buyers (including me) to try to buy over $200 in merchandise. The extra revenue creates incremental product margin dollars and decreases shipping cost as a percentage of revenue. This in turn increases GM$.

For a subscription company this can be done by scheduling less frequent (larger) deliveries. The shipping cost of the larger order will be a much smaller percent of revenue, raising GM.

  • Opening a Second distribution center to reduce shipping cost. Orders shipped from a west coast distribution center to an east coast customer will have 5 zone pricing. By having a second distribution center in a place like Columbus, Ohio (a frequently used location) those same orders will usually be 1 zone, sometimes 2 zone pricing, resulting in substantial savings per order. The caveat here is that a company needs enough volume for the total savings on orders to exceed the fixed cost of a second distribution center.

5. Improving CM by driving “free” or “nearly free” traffic

The higher the proportion of free or inexpensive traffic to total traffic, the lower the blended CAC.

  • Improving SEO (search engine optimization). I’ve learned from SEO experts that optimizing SEO is not free, but rather very low cost compared to paid traffic. Our previous post walks through some of the science involved in making improvements. I would suggest using an SEO consultant as it is likely to lead to far better results.
  • Convert a visitor not ready to buy to an email recipient. If you do that than you will have subsequent opportunities to market to her or him. A slightly costlier version of this is to use remarketing to woo visitors who came to your site but didn’t buy. While using remarketing (advertising) has a cost, it is usually much lower CAC than other methods.
  • Produce emails that get forwarded and go viral. Such emails need to motivate recipients to forward them due to being very funny, of human interest, etc. While there is typically a product offering embedded in them, the header emphasizes the reason to read it. One Azure portfolio company, Shinesty, recently had an email that was opened by about 7X the number of people it was initially sent to.  That generated a lot of potential customers without spending extra marketing dollars. Engaging emails has enabled Shinesty to maintain high CM and high growth.
  • Use social networking to generate incremental customers. Having the right posts on a social network like Instagram can lead to new potential customers finding out about you and lead to additional sales.
  • Optimize Customer Retention. Or as my good friend Chris Bruzzo (CMO of EA) spoke about at the Azure Marketing conference: “Love the ones you’re with.” Existing customers are usually the largest source of “free” buyers in a period. The longer you retain a customer, the more repeat buyers you have, increasing contribution margin. So, it’s imperative to take great care of your existing customers.
  • Drive PR. Like SEO, there is some cost involved in this but if you are judicious in any agency spend and thoughtful in creating news worthy press releases this can be a great source of traffic at a modest cost. However, I recommend you try to understand what you are getting from PR because I have seen situations where the spend did not produce meaningful results.

6. Decrease Marketing Spend as a % of Revenue.

The CAC Recovery Time plays a major role in how to manage your market spend to balance growth and burn. For example, if CAC Recovery Time is one month, spending more will not drive up burn appreciably. If it takes more than a year to recover your CAC, moderating market spend is critical to achieving a reasonable CM. If you recoup CAC faster, you can invest more quickly in the next round of customers. In the consumer space, I won’t invest in a company that has a long (a year or more) CAC Recovery Time as customers are likely to churn in an average of 2-3 years, making it difficult to achieve a reasonable business model. For B2B company’s customer longevity tends to be much longer, and the LTV/CAC can be 5X or more even if CAC Recovery Time is a year.

When a company decreases its market spend as a % of revenue it may experience lower growth but better CM. However, many companies have waste in their marketing spend so it’s important to measure the efficacy of each area of spend separately and to eliminate programs with a low return. This will allow you to reduce the spend with minimal impact on growth rates. There is a balance needed to try to optimize the relationship between CM and revenue growth as higher burn requires raising money more frequently and can put your company at risk. On the other hand, a company generating $1M in revenue needs to be growing at 100% or more to warrant most VCs to consider investing. Since CM should improve with scale, spending more on marketing may be a viable strategy for early stage companies. Once a company reaches $10M in revenue, annual growth of 50% will get it to $76M in revenue in 5 years so such a company should consider better CM rather than driving much higher growth rates and continuing to burn excessive cash.

In summary, Contribution Margin is the lifeblood of a company. If it is weak, the company is likely to fail over time. If it is strong and revenue growth is high, success seems likely. Improving CM is an ongoing process. I realize many of you probably feel much of what I’ve said is obvious, but my question is:“How many of these suggestions are you already doing on a regular basis?”

While you may be using several of the suggestions in this post, I encourage you to try more and to also double down where you can on the ones you already are trying. The results will make your company more valuable!

 

SoundBytes

  • I just want to remind readers that my collaborator on my blog posts, Andrea Drager, doesn’t typically take a bow for her significant contributions. Also, in this post, Chris Bruzzo added several improvements that have been incorporated. So many thanks to Andrea and Chris.
  • Can’t help but comment on the start to the NBA season. Not surprisingly, the Warriors are off to a great start with Curry and Durant leading the way. Greene and Thompson now have moved close to their usual contribution so I’m hopeful that the team can keep up its current pace.
  • What surprised me early on was the lack of recognition that both Toronto and San Antonio would be greatly improved. Remember, while San Antonio lost Kawhi, he only played a few games last year so with the addition of DeRozan should improve and once again reach the playoffs. For Toronto the change to Kawhi is a marked improvement placing them very competitive with the Celtics for eastern leadership.
  • I also feel it necessary to comment on the “Las Vegas” Raiders. I call them that already as they have shown zero regard for Oakland fans. While commentators have criticized their trading of all-star level players for draft choices, this is precisely on-strategy. When they get to Vegas they want a brand-new set of rising stars that the new fan base can identify with (using the numerous first round draft choices they traded for), and they don’t mind having the worst record in the league while still in Oakland. I believe Oakland fans should stop attending games as a response. I also think the NFL continues to shoot itself in the foot, allowing one of the most loyal and visible fan bases in the league to once again be abandoned

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