What is Contribution Margin —Should You Be Tracking It?

It’s no secret at Omnitail we don’t necessarily follow the standard agency metrics – like ROAS and A/S. In fact, it’s right in our name: We’re “The Profit-Driven Marketing Agency.” New clients are often surprised to find, though, that the monthly reports they receive don’t contain any metrics labeled “profit.” Instead, they’re built around two other industry metrics: contribution, and contribution margin. As we onboard and work with these clients, we’re often asked, “What are contribution and contribution margin?”

What is Contribution?

The simple answer is “profit” – or rather, the amount that paid ads as a channel contribute to overall operating profit.  In-depth, contribution refers to the dollars leftover after cost of goods, other variable costs, and ad spend have all been accounted for. For example, you might accrue $1,000 in revenue from paid ads in a given month. The cost of the goods you’re selling averages 35% of revenue (so for this chunk of revenue, cost of goods will account for $350), and your monthly shipping cost for sales attributed to paid ads is $100. You’ve also spent $200 on advertising.  Here’s how that would shake out:

Of your $1,000 in revenue from paid ads, you’ll keep $350 as profit, or as contribution to overall operating profit. We use this metric, along with contribution margin, to drive our bidding strategy and make other decisions about a given account’s management.

What is Contribution Margin?

Contribution margin, also known as contribution rate, is a measure of profit as a percentage of revenue.  In the example above, $350 remained as profit from $1,000 total revenue – a 35% contribution margin. Not bad! You can also think of it as the percentage of revenue that contributes to fixed costs after accounting for your variable costs (like the shipping costs and ad spend listed above.

Why Not Use ROAS or A/S?

ROAS and A/S have their place (and are included in our monthly reporting) — we just don’t rely on them alone. These two metrics can help inform our decision-making, however.

ROAS

At Omnitail, we employ ROAS as a metric to inform decision-making. ROAS doesn’t account for other considerations such as COGS, variable overhead expenses, return rates, or customer lifetime value (LTV), so it’s not ideal to base your entire strategy around it, but it can be an informative metric when evaluating the impact of diminishing returns on incremental marketing investment.

Ad Spend To Sales Ratio (A/S)

Ad Spend to Sales (A/S) is synonymous with Cost of Sale (COS) and Effective Revenue Share (ERS) and is the inverse of ROAS. It’s an efficiency metric, not a measurement of profitability. Because of that, (and because the Ad to Sales ratio doesn’t account for the cost of goods or variable overhead expenses) we typically don’t rely on it as a primary KPI.

Like ROAS, though, it can be useful in determining the impact of diminishing returns on incremental marketing investment.

Curious about your profitability? Contact us for a free marginal ROI analysis!