In 2014, a viral video depicted a scene that would have been hilarious, if it hadn’t been so sobering. It started with bystanders attempting to save a winter sledder, who had broken through the ice of a California lake. The rescue was so badly botched, that in the end, 11 more people had to be pulled from the freezing water.
Have you ever seen this kind of thing happen to a business? I have.
If you’re like many businesses, you may feel like you are constantly treading water in a freezing lake. You’re just a few moments from going under, but there’s hope. All you have to do is get a solid online marketing campaign up and your business will be saved, right?
Online marketing certainly has the potential to save your company, but if you invest in the wrong channel, your marketing spend will be less like a life jacket and more like a cannon on your bootstraps. But unlike sledders swimming in an icy lake, many companies can’t tell whether their marketing efforts are pulling them to shore or pulling them under.
Fortunately, if you’re wondering whether or not a particular marketing channel is helping or hurting your business, I’ve got three words for you: Contribution margin ratio.
Crunch the numbers
Ok, I’ll admit those are probably not the three sexiest words I’ve ever strung together. They’re accounting words, and it’s unlikely that you were drawn to business by the glowing prospect of crunching numbers. But what if I told you a little number crunching could save your business? Trust me, it could.
Luckily, the equation for calculating contribution margin is a cinch.
In accounting terms, contribution margin ratio (CMR) equals sales divided by variable costs. In plainer language, it’s what you made from sales divided by how much you spent on marketing and fulfillment.
Calculating Contribution Margin Ratio
Essentially, variable costs are company expenses that increase as sales increase. There are certain costs that come with fulfilling a sale – things like manufacturing, packaging and shipping. These are your variable costs.
On the other hand, as you spend more on marketing, the more sales you make, at least theoretically.
Unfortunately, if your marketing stinks, then you won’t generate enough revenue from sales to make the investment worthwhile. So how do you know whether a particular marketing channel is helping or hurting your business? Well, let’s calculate a CMR for your marketing.
Marketing Contribution Margin Ratio
So, if you spend $1,000 on marketing, and make $500 in sales, your marketing CMR is 0.5. If you spend $1,000 and make $10,000, your CMR is 10.
Obviously, bigger is better, but how big is big enough?
In my experience, a CMR of three is enough to break even. Above a three, you’re making money. Below it, you’re losing money.
Related: Target Your Market… Or Die
What does this look like in real life?
In case this is all seems a little abstract, let’s see how this works for a hypothetical business. For example, pretend you started a small business a few years back giving aerial tours of the Grand Canyon.
Your plane seats one passenger, and you charge $150 per flight. You haven’t done much marketing, but you have a steady flow of about 20 ticket sales per month from talking to people yourself (direct sales), loyal repeat customers and word-of-mouth referrals.
You’re making $3,000 a month before you factor in your expenses.
Unfortunately, each flight costs you $75 in airplane fuel, wear and tear and other flight costs. That leaves you with $1,500 in profit.
That might be a nice little business, but your costs don’t stop there. You also spend about $2,000 a month on your airstrip mortgage, office utilities and plane maintenance. We call these fixed costs because you have to pay them whether or not you’re making sales.
The long and short of it is: You’re in the hole $500 every month. Or, in other words, your business is sinking.
Now what? You don’t have the money to buy a bigger plane, and you’ll lose the customers you have if you increase your prices. However, you discover that you’re missing out on a lot of sales because most tourists plan their trips online before they travel, and you don’t have an online presence.
In an effort to get your business moving in the right direction, you decide to try online marketing – listings on travel websites, pay-per-click ads and promotional email campaigns.
The only question is, how effective does your marketing have to be to break even?
1X Contribution Margin Ratio
What if you made one $150 sale for every $150 you spent on marketing? That’s break-even, right?
Remember all those fixed and variable costs that were eating up your profit margin in the first place? If you spend as much as you make, you’ll never make any headway against your $500 deficit. Your marketing CMR may be 1X, but you end up losing money on every sale in fulfillment costs ($75, to be precise).
Take a look:
2X Contribution Margin Ratio
What about a 2X contribution margin ratio? If you spend only $75 on marketing to make a $150 sale, you’ll offset your fulfillment costs, right? That’s true, but you still won’t be making any progress against that $500 deficit in your budget from your fixed costs.
3X Contribution Margin Ratio
But what if your marketing was even more efficient? What if you spent $50 on marketing to produce a $150 sale? At a 3X CMR, you finally start to break even as long as you can get at least 20 sales from your online marketing efforts.
Even after you hit a 3X multiple though, it’s still slow going. Your marketing is sustainable, but you can’t really grow your business on this sort of margin. After all, you can probably only make around 40 flights in a given month, which just gets you to your break even point.
4X Contribution Margin Ratio
If you really want to make a profit on your campaigns, you need to get them to produce at least a $4 in revenue for every $1 you spend on advertising.
Now you’re breaking even after 14 sales. If you make 40 flights in a month, you only have to pay for marketing and fulfillment on six flights. At $37.50 of profit per flight, you make $225 per month. All of a sudden, your online marketing is starting to make a lot more sense.
5X Contribution Margin Ratio
Once you hit a 5X contribution margin, you are finally in a good position to start using your online marketing to actually grow your business. You break even at about 11 sales, which means that your last nine sales net you $405 in profit each month.
With that kind of profitability in hand, you may be able to take out a loan, and get a bigger plane, allowing you to book two to four times as many tickets. Your expenses might go up a bit, but if you can fill between 80 and 160 seats a month, you are in a good position to really start making some money.
Here’s the moral of the story
Is this whole contribution margin ratio thing starting to make sense? Good. Let’s boil all that math down into a simple rule of thumb.
- If your marketing CMR is three or below, rethink your marketing. You’re probably losing money.
- At a 4X CMR, your marketing is turning a profit.
- If your marketing CMR is five or higher, you can use online marketing to grow your company.
This is how to up your marketing CMR.
By now you’re probably thinking, “Great, I want a big CMR, but in your story you just arbitrarily upped the CMR. How do I do that in real life?”
Good question. In fact, that’s a question I’ve devoted my career to answering.
The specific answer varies by business, but most companies struggle to reach a 4-5X contribution margin ratio for one reason: They spend their online marketing budget in the wrong places.
Take AdWords, for example. The average AdWords account wastes 76 percent of its budget on search terms that never produce conversions, let alone sales. So if your AdWords campaigns are running at a 3X multiple, the easiest way to get to a 5X or better multiple is to stop wasting money on the wrong keywords.
For example, we’ve had clients triple their sales by simply taking their wasted ad spend and redirecting it into more effective campaigns. As a result, these companies have grown by leaps and bounds and made millions in profit.
Can you imagine what going from a 2-3X CMR to a 6-9X CMR would do for your business?
Find your current CMR
Calculating your marketing CMR is actually fairly easy. You just need to know the following.
- How many sales your online marketing has produced.
- The average customer lifetime value (LTV) of your online marketing sales (for help figuring this out, click here).
- How much you’ve spent on online marketing.
Then it’s right back to the equation from the beginning of the post.
Plug the number you get into my rule of thumb, and you’ll have a good feel for how effective your marketing is.
Here’s the takeaways
Over my career, I’ve met, talked and worked with thousands of entrepreneurs and business owners. Without fail, the success or failure of these companies revolved around their CMR.
Below 3X, companies struggle and die. At 3X, they survive, but just barely. Only the companies that reach a 4X or better CMR thrive. It’s a simple rule of thumb, but an effective one.
So, if you want your online marketing efforts to keep your business afloat, they must be driving at least $3 in revenue for every dollar you spend. Otherwise, your company probably won’t survive.
This article was originally posted here on Entrepreneur.com.