The Great Gross Margin Debate
Ampla has a standard approach to margin analysis that includes three metrics: product margin, gross margin, and contribution margin. Learn how these metrics help to understand the different factors that impact bottom line, including product costs, transportation costs, marketing costs, and other variable expenses.
If you've logged on to DTC / CPG Twitter in the last few months, you've undoubtedly seen a good bit of spirited debate about what does or does not constitute gross margin (GM) in the world of eCommerce consumer products.
Should GM simply be pure product costs? Does it include transportation/shipping? If so, is it just freight from the factory to the warehouse, or do you include the delivery to the end customer? And then there's the elephant in the room for all eComm brands: marketing costs.
While there's nuance and different calculations for different audiences, Ampla has a standard approach we believe is useful and applicable to lenders and investors as well as a brand's internal management.
For Ampla and many like-minded operators, there are three types of margin analyses that are important: Product margin, gross margin, and contribution margin.
This is a metric that is primarily driven by the cost of your product. It is calculated quite simply as your net sales, less the cost your manufacturer charges you to produce your product. To visualize this as a percentage, divide this figure by your net sales.
There are two main levers you can pull to optimize this metric: 1) reducing your cost of goods either via volume discounts or switching up the type of materials you use and 2) adjusting your retail price. Target product margins will vary according to industry and distribution strategy, but based on the brands within our purview, they can range from 30-50% for wholesale and 50-80% for direct-to-consumer.
Calculating gross margin is where we see a lot more variability depending on the brand, the operator, and the audience. For this metric, we layer in additional costs, mostly related to transportation and getting products from the factory to end customer. Specifically, in addition to COGS, you account for freight from your manufacturer to your warehouse, any and all warehouse fees (receiving, storage, pick-pack, etc), and shipping costs to your end customer.
In our opinion, the main reason to separate product margin and gross margin is that many of the transportation costs in gross margin have been particularly volatile over the last several years, as well as greater storage fees resulting from the dissonance between inventory forecasting and true consumer demand. The latter has seen its gap grow as CPG’s face unprecedented demand volatility and it is important to highlight the economic implications of overstocking. From inflation and unpredictable consumer demand to supply chain disruptions, we believe parsing these costs from production costs is key to understanding how each is independently impacting your unit economics and bottom line.
Outside of transportation and warehouse fees, we've also seen some brands include other "direct selling" fees, such as marketplace and platform fees, credit card processing fees, any BNPL fees, etc., but we typically roll those into the third margin analysis, contribution margin.
Perhaps the best metric to judge the overall health of your commerce business is contribution margin. In addition to production and transportation, this metric includes all other variable costs it takes to sell your product. As referenced above, at Ampla, we include platform and processing fees in the contribution margin, as these are different for each business depending on their primary sales channel and overall distribution mix.
In the world of eCommerce and consumer products, the largest variable costs we see are related to marketing and sales. In fact, these costs can swing a product from being highly profitable on a gross margin basis to wildly unprofitable in terms of its contribution to the bottom line. For example, let’s say you are selling a high-end candle for $55, and between COGs, shipping, direct selling fees, etc., you have a gross margin of 60% or $33, which is strong. However, your cost to sell this product and acquire a customer – between commissions paid to affiliate partners, digital paid ads, etc. – is $50 because you’re competing in a very saturated category; this would result in a negative contribution margin.
This fictitious scenario has become more and more real over the last 18 months as digital performance media costs have risen and more and more brands launch every day. Maintaining a positive contribution margin for many brands in our ecosystem typically means keeping marketing and sales costs in check. This is easier said than done, but key levers to pull include: 1) focusing on lifecycle and retention marketing (link to past article) which can offset and explain away negative contribution margins to investors, 2) layering in a wholesale strategy, 3) diversifying your digital marketing away from just paid performance and into more profitable channels such as affiliate.