CPG Gross Margins: Ecommerce vs Retail Channels
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Originally published on LinkedIn on Sep 7, 2022
The short story (for this article)
Comparing gross margin targets and achievements between ecommerce and bricks 'n mortar channels can be a frustrating and futile exercise. Focus on Dollar Sales Contribution per unit instead! That is the case that this article is putting forward.
Are you calculating gross margin correctly?
My previous article, Not all Gross Margins are created equal, addressed some of the most common misconceptions or omissions when calculating and comparing gross margins. It is fairly common to come across Emerging CPG Brands that are calculating their gross margins incorrectly. Not surprisingly then, the consequences for setting prices and for targeting Cost of Goods Sold (COGS) levels, when using incorrect margin targets, can be quite significant and can lead to poor trade-off decisions.
That article primarily focused on the preferred approach to measuring trade marketing expenses, gross margins and sales contribution within traditional distributor-retailer bricks 'n mortar channels. But what about ecommerce and Direct-to-Consumer (DTC) channels? A question that is increasingly prevalent in discussions with fellow founders, industry forums and client work.
Bricks 'n mortar vs ecommerce margins: Illustrative scenarios
It is difficult to discuss and compare gross margins without contextualizing them with their underpinning numbers. There are many blogs and articles out there that talk margins but never show the why, what and how. Within this article, a set of illustrative profit and loss (P&L) mini statement scenarios are used to compare and discuss margins for the same SKU that is sold a) via a traditional bricks 'n mortar channel and b) via an ecommerce platform.
For this article, ecommerce is used interchangeably with direct-to consumer (D2C, DTC).
The bricks 'n mortar gross margin and sales contribution scenario
The bricks 'n mortar scenario represents the supermarket sales of a shelf-stable brand stock keeping unit (SKU) that retails at a suggested retail price (SRP) of $5. Sales volumes, for the period analyzed, amount to 220,000 consumption units as sold "off the shelf".
The brand and SKU is considered to be an emerging brand in a competitive category and, thus, trade marketing expenses are fluctuating at 23% of gross sales for the period.
The product is produced at the brand's manufacturing facility. Retail sales at the supermarket are serviced through a distributor, and products are shipped to the distributor warehouse via a 3rd party logistics (3PL) carrier. For this channel and illustrative example, the gross margin for the period was 40% of net sales.
The sales contribution amounted to 22% of net sales and $0.41 per consumption unit.
For the bricks 'n mortar scenario, the following represents the base situation with which to compare the ecommerce scenarios.
23% trade marketing expense as a % of gross sales
40% gross margin as a % of net sales
22% sales contribution as a % of net sales
Are these expense and margin percentages considered decent? This is discussed further on in the article.
The ecommerce gross margin and sales contribution scenarios
Two ecommerce or direct-to-consumer (DTC) scenarios illustrate the type of ecommerce economics for the same product, pricing and quantities that were examined in the bricks 'n mortar example. For the ecommerce channel, the same consumption units are sold as a 4-pack for a total unpromoted platform price of $20 per 4-pack selling unit.
The ecommerce platform price point of $20 was used to maintain the same $5 per consumption unit price point as sold in the bricks and mortar channel.
The sales volume of the multi-packs via the ecommerce channel amounted to 55,000 selling units, which equates to 220,000 consumption units. The scenarios are set this way so that gross margins can be compared against gross sales of $1.1 million that are the same for the ecommerce and bricks 'n mortar channel.
The expense allocation approach impacts the % margin
Emerging CPG Brands that either sell exclusively via online channels or that have both bricks 'n mortar and fast-growing ecommerce business models seem to adopt different approaches when accounting for marketing, selling and fulfillment expenses.
These different allocation approaches result in a situation where the gross margin Dollars and percentages are different. This can make margin comparisons of brands selling via ecommerce channels meaningless. It also impedes the ability to make insightful trade-off comparisons with brick 'n mortar channels.
For both ecommerce DTC scenarios, the multi-packs are sold via Amazon's FBA (Fulfillment by Amazon) program, which is the most widely used service for selling on Amazon as a third party (3P) seller.
In Option #1, the price per click (PPC), price per mille (PPM) ad spend costs, selling fees and fulfillment fees are all expensed to yield the $ 363,000 net sales for the period.
In Option #2, the selling fees and fulfillment fees are expensed under direct selling expenses. This is similar to how selling, broker and logistics fees would (or should) be treated in a bricks 'n mortar channel. This allocation approach yields a $728,000 net sales for the period.
In any ecommerce and DTC business model you have to get your product to Amazon so you will still incur outbound logistics costs. For the two ecommerce scenarios the outbound logistics costs are lower than that of the bricks 'n mortar scenario as you would in all likelihood, be delivering bulk product to fewer regional or national locations. However, the $6,000 for the period is unrealistically low. This was set purposefully at this level, to highlight the minimum outbound logistics costs needed to yield the same total sales contribution Dollars achieved in a bricks 'n mortar channel. (The Ecommerce Reality scenario, illustrated later corrects this.)
The same sales contribution $. Different margin percentages!
The table below summarizes how the different allocation approaches impact the resultant spend and margin percentages, even if the gross sales and bottom-line margin Dollars are the same!
How and where you allocate ad spend, discounts, selling and fulfillment fees determines the resultant amounts used to derive a) the trade-spend equivalent for ecommerce as a % of gross platform sales, and b) the net sales vs. the gross platform sales relationship that is used to derive the gross margin.
So why are emerging CPG brands using different allocation approaches? What I have observed is that the manner in which a brand receives its net earnings from the ecommerce platform, sometimes, influences the manner in which those amounts are then accounted for and allocated.
Comparing spend and margin percentages should be meaningful
How should you allocate? The option #2 allocation approach is my recommendation as a preferred approach. This ecommerce approach is aligned with the preferred gross margin and sales contribution allocation approach used for bricks 'n mortar channels. What you might also find is that Option #2 aligns closer with a bricks 'n mortar channel comparison where the brands are sold directly to the retailer. (The bricks 'n mortar scenario in this article depicts a distributor-retailer pathway).
As is evident in the channel comparisons above, the trade marketing spend (direct marketing spend) and margin percentage comparisons are significantly different. That is why it can become a frustrating and, sometimes, futile exercise to compare spend and margin percentages across go-to-market channels whose business models and characteristics differ considerably. The same argument could, perhaps, be applied to the comparison of different bricks 'n mortar channels.
Comparisons and margin "constructs" are meaningful when the comparative spend and margin percentages can help you make insightful trade-offs on where, when and how to spend limited resources:
Between different business model channels, and
Within channels where the business model and market characteristics are similar.
While better-constructed margin metrics can be illuminating, these metrics can be more meaningful and instructive if used with certain unit economic measures.
Sales contribution per consumption unit is the truth teller
You may have noticed something particular in all the scenarios thus far. Irrespective of how expense and margin % measurements are constructed, due to the various expense allocation approaches, there is one measurement metric that did not change.
The Sales Contribution per consumption unit (or per selling unit depending on what you are comparing) will always allow you to credibly measure and compare profitability between and within channels. This unit economics measure should be used in conjunction with expense and margin percentage measures.
Is ecommerce versus bricks 'n mortar profitability a slam dunk?
You might recall that for both ecommerce options 1 and 2, the outbound logistics for the period was deliberately set to the unrealistic $6,000 per period for these scenarios. The outbound logistical costs to Amazon or to a 3rd party logistics (3PL) service provider might not be as high as that of the brick 'n mortar scenario where logistics to various distributor warehouses could be more complex and extensive. What if the outbound logistics is more in the range of two thirds of the bricks 'n mortar scenario? This is the Ecommerce or DTC Reality scenario.
The addition of more realistic outbound logistics costs for this Amazon FBA scenario now reduces the sales contribution per consumption unit from $0.41 to $0.34, while the gross margin of 63% has remained the same when compared to the ecommerce option #2 scenario.
The point here is to highlight how, for certain brands and SKUs, the sales contribution unit margin in ecommerce channels can be lower than that achieved in bricks 'n mortar channels.
If you consider all the ad, selling, fulfillment and logistics expenses that marketing and selling through an ecommerce channel requires, you can now see why not all emerging CPG brands are able to sustainably succeed in this channel. This reality is further amplified if your brand and SKU has a short-shelf life and/or needs a refrigerated supply and fulfillment chain.
Ecommerce ad spend, selling and fulfillment fees are not insignificant. Let's explore this further by using Amazon FBA as an example. (Note: There are other fulfillment options, and they can be more expensive or less expensive than Amazon FBA. Analyzing and modeling your options always helps.)
Amazon FBA is convenient, but you pay for that value
Amazon Retail, where Amazon acts as the first-party (1P) seller, have changed their business model. They are now mostly only buying direct, via their Vendor Central platform, from larger incumbent brands or from some smaller but fast nationally-growing brands.
Amazon's FBA (Fulfillment by Amazon) program is the most widely used service for selling on Amazon as a third party seller. Selling and fulfillment fees charged by Amazon, where you sell as a third-party (3P) seller, are based on a) the 15% selling fee or a minimum amount, and b) the category fulfillment, storage and other fees charged for a selling unit of the size and weight associated with that selling unit.
For the ecommerce illustrative scenarios, the total selling and fulfillment costs amounted to $365,000 for the period. This is not cheap if you consider that this equates to $1.66 per consumption unit, or $6.64 per multi-pack or $19.92 per case (if there are 3 multi-packs in a case). Having said that, Amazon's FBA program handles all the picking, packing, shipping and returns for you! That is why FBA is popular with so many emerging CPG brands.
Unless you've gone viral, ecommerce ad spend adds up
Just like for the bricks 'n mortar world, unless your are part of the hard-working and lucky few whose brand resonated and has virally exploded when launched, you will be spending a significant amount of constrained funds on online ads. Spending on trade marketing in bricks 'n mortar channels is no different. Getting your brand and SKU to the physical or virtual shelf is the first challenge. Enticing a customer or consumer to consistently pull your brand "off the shelf" is the tougher challenge!
Just like in the bricks 'n mortar world you will have ecommerce shoppers who represent organic and repeat sales and you will have shoppers who will need that digital brand stimulus and discount enticement. For ecommerce and DTC, ad spend via a platform and via social media platforms like Instagram, Facebook and TikTok implies that you need to purchase impressions and clickthrough’s in sufficient quantities to generate order conversions.
For the ecommerce and DTC scenarios, an amount of $308,000 would have to be spent to contribute to the non-organic portion of the 55,000 4-pack sales, given reasonable clickthrough rates and order conversions on Amazon FBA. This level of direct marketing spend is also not cheap if you consider that this equates to $1.40 per consumption unit, or $5.60 per multi-pack or $16.80 per case (if there are 3 multi-packs in a case).
You can shoo the dog away, but it will always come back to bite
I have also found that emerging CPG brands and smaller established brand companies are in some cases allocating most of their digital ad spend to the marketing line item in the SG&A (Selling, General & Administrative) overhead bucket. In other cases, online ad spend is being capitalized if it can meet certain accounting-standard criteria
The dilemma here is that by "diverting" digital ad spend, which can be significant, and which is necessary to secure ecommerce and DTC order purchasing conversions, this ad spend is being masked and is therefore artificially inflating any type of gross margin or sales contribution that is being measured. Hiding it does not take away the reality that cash is consumed weekly and monthly to pay for that spend!
It is acknowledged that there are credible cases and accounting reasons for why certain ad spend can be capitalized or be expensed within a "fixed" overhead bucket. I am certainly in agreement with ad spend being allocated to SG&A where, as a strategy, the ongoing and necessary investment in digital ad spend is primarily geared to drive and build brand awareness via impressions. This is usually achieved via PPM (Pay per Mille) campaigns.
In bricks 'n mortar channels, trade marketing expenses can cover promotions, sampling, physical shelf display, point-of-sale marketing collateral and store-oriented digital displays. All this trade marketing spend does contribute to brand awareness and brand-building, but mostly it is intended to entice a shopper or customer to choose and buy that product, there and then. Trade marketing expenses are there to drive trial and purchase conversion!
Similarly for ecommerce, PPM (Pay per Mille) ad impressions and PPC (Pay per Click) ad spend is intended to drive a purchase (a conversion). This is analogous to trade marketing spend and should therefore be allocated and accounted for in that manner.
Note: CPC (Cost per Click) and PPC (Pay per Click) is sometimes used interchangeably. CPM (Cost per Mille) and PPM (Pay per Mille) is also sometimes used interchangeably. PPC and PPM however normally refers to the wider campaign program with all its programing details. CPC and CPM is used specifically for the actual cost associated with each click or mille (1000s).
Trade marketing vs. digital ad spend + discounts
The trade marketing expense "equivalent" in the ecommerce scenario is 34% of Gross Platform Sales versus the 23% of Gross Sales to Distributor.
Nowadays, digital shelf space is even more cluttered and more proliferated than physical shelf-space. It is not that surprising that you might be spending 1.5X more in direct marketing and ad expenses in an ecommerce versus a bricks 'n mortar channel.
Partnering with the right PPC/SEO service provider that can help you maximize your order conversion rate while lowering your average cost per click (CPC). This can help reduce your overall ad spend per selling and consumption units.
I thought 15% Trade Marketing Expense was sufficient?
A target of 15% Trade Marketing Expense of Gross Sales is often recommended for bricks 'n mortar channels. However, the hyper-competitive brand/SKU proliferation, that is a reality for most emerging CPG brands nowadays, can necessitate a higher spend level.
As many emerging CPG founders will attest to, it is not uncommon to experience even higher charges reflected on invoices received from distributors. Thankfully there are great trade spend software and service solutions out there that can help you manage trade marketing spend and eliminate or even reverse predatory charges.
A good starting point is to smartly plan and consider the level of trade marketing spend that you will need to build the brand at retail. Trade Spend levels of 15% or 20% of gross sales, for bricks 'n mortar channels represents a significant amount of cash flow that needs to be planned for and financed!
The Ecommerce and DTC equivalent of trade marketing spend is direct marketing expenses. These expenses include digital ad spend that is targeting conversions as well as promotional discounts and digital coupons that are offered. I don't yet have sufficient data on this, but I suspect that, as per the ecommerce scenarios, it is unlikely this amount would be less than 25% of gross platform sales (as measured via the option #2 approach). Just like in bricks 'n mortar business models, the direct marketing spend levels will vary by ecommerce channel, and category.
If any readers have anecdotal or other insights with regards to "optimum" direct marketing spend level for CPG categories, it would be of value to all to add those in the comments section of this article.
Low gross margins do not deliver much-needed cash flow
A 40% gross margin percentage (GM%) when selling via a distributor-to-retailer bricks 'n mortar channel represents a minimum threshold for many categories.
Many successful founders and savvy investors will validate that. This 40% GM threshold also assumes that the brand has correctly accounted for trade marketing expenses. My previous article mentioned earlier, expands on this further.
Yet, for many startup CPG brands, even achieving 40% GM in a bricks 'n mortar channel is a tough goal. Many are in the low to mid 30% range. I have been there!
Achieving a 45% GM of Net Sales now, is what is ideally needed for most emerging CPG brands.
Depending on the category, and as per the Option #2 scenario, the GM% would need to be upwards of 65% for ecommerce channels.
A high gross margin that is coupled with above-category-average velocities will vastly increase your chances of success.
As CPG entrepreneurs we hope and often perform spreadsheet magic that convinces us that scale will eventually get us there and vastly improve our low 30 GM% in bricks 'n mortar channels or low 50% GM% if selling via ecommerce channels. Yes, this can happen if SKU velocities are on fire and if brands are able to finance and roll-out distribution (and trade spend/direct marketing) in a disciplined manner. Unfortunately, for many brands, this is an outcome that seldom materializes.
Gross Margins in the low to mid 40% range for bricks 'n mortar channels or mid to high 60% range for ecommerce channels range are needed because commissions, broker fees, selling fees and highly volatile and increasingly-expensive fulfillment, outbound logistics and warehousing costs still need to be paid.
That gets us to Sales Contribution, the margin where there is no room left to hide. Sales Contribution is the margin that can prevent the allocation games that are sometimes used to show higher gross margins because certain expenses have inappropriately been allocated "below the gross margin line" or that have been pushed in to fixed expenses categories.
Sales Contribution is the new Gross Margin
Sales Contribution is an even more important and relevant financial brand health metric than Gross Margin. It is the margin that should reflect the totality of all your direct variable or semi-variable costs needed on a "daily basis" to put your brand in the hands of a shopper and ultimately a consumer. Sales Contribution reflects the margin Dollars available to PAY your fixed overheads and SG&A!
Sales Contribution represents your true breakeven. You need to target 40 to 45% Gross Margin of net sales for bricks 'n mortar channels or 65 to 70% GM% for ecommerce and DTC channels so that you have enough money (note: money is not cash) left over after paying for direct selling expenses.
Note: The 40 to 45% GM of Net Sales range, depending on the category, is a guideline for a brand and SKU that is sold via a distributor-retailer route-to-market.
If you are selling direct to retailers, your gross margin % of net sales should be higher as you do not have a distributor or wholesaler level. Retailers are, however, increasingly pressurizing brands to capture the Dollar margins that distributors would make when setting up direct to retailer relationships.
Depending on the category and depending on the scale of your overheads, the resultant Sales Contribution as a % of net sales should at the very least, be in the low 20% range. A mid 20% Sales Contribution % of Net Sales is preferable for a decent shot at success in the early non-scale era of your brand. This is a tough challenge for many startup and emerging CPG brands.
For our illustrative bricks 'n mortar example, the Sales Contribution as a % of Net Sales amounts to 22%. This represents a Sales Contribution of $0.41 for every consumption unit that is sold. If your fixed overheads are $70,000 for that period, your breakeven would be about 171,000 consumption units or about 14,200 cases (if there are 12 consumption units to a case).
Are there sales contribution trade-offs in bricks 'n mortar?
There are some trade-off decisions that can be made here. Let's say that, as an emerging CPG brand, you have invested in your own manufacturing capability and wish to leverage some early-stage excess capacity. Would you produce a product that is NOT competitive with your own core brand but one that can be sold to a hard discounter retailer (e.g. like an Aldi) knowing that the sales contribution % is likely to be in the mid to high teens?
Given that some of these hard discounters will likely pick up that product in large bulk orders and pay you in a much shorter time period than distributors or traditional retailers, the answer might be a resounding yes.
In this situation, lower sales contribution % Dollars derived from a product that does NOT jeopardize the brand equity and pricing of your core brand and that can help with your cashflow and pay for overheads is a worthwhile consideration and trade-off!
Incidentally, and on the topic of hard discounters and ecommerce, Jan-Benedict Steenkamp asserts that "online retail is not the main disruptor in the world's single biggest retail market - grocery retail." Rather, he argues, it is hard discounters!
Why do I even bring this up? My own belief is that the risk of hard discounters for traditional retailers is a risk that would mostly impact the large incumbent brands. Surely, this opens up an opportunity for emerging CPG brands to a) provide higher margin value for those conventional supermarkets and grocers and b) offer a distinctive brand online! And, if you get a chance to cover overhead and secure much needed cashflow by leveraging some capacity...well that, as they say, is some much needed gravy!
Multi-packs can help increase Sales Contribution per unit
For ecommerce and DTC sales, the possibility of marketing a unique multi-pack for that channel should be seriously explored. Unique here means a multi-pack that is different versus the types of pack sizes that the brand would typically sell in brick 'n mortar channels. There are three reasons why a unique multi-pack offering can help:
The revenue from each order and sale is higher (vs. selling single consumption units) and therefore helps to cover the high digital ad spend that is usually generated on a per order expense basis. A larger amount of consumption units per order yields a lower ad spend per consumption unit!
An ecommerce unique multi-pack can potentially be offered at a slightly higher price-point given that customers and consumers would not be able to purchase that same type of pack in bricks 'n mortar channels. This approach also allows brands to avoid the situation with there is an expectation by large third-party seller platforms like Amazon and Walmart.com to offer brands and SKUs that are at parity or even cheaper online versus bricks 'n mortar channels.
Bricks 'n Mortar wholesalers and distributors can and do sell brands and SKUs online. It is a known practice that distributors can purchase more of a brand's brick 'n mortar offering during a quarterly discount period (e.g. 15% off invoice programs) and then offer that same product online at a price that undercuts your own online price and brand building strategy. Unique multi-packs can help minimize this form of price arbitrage.
Optimizing key drivers amplify to deliver large margin impacts
The economics of ecommerce and DTC business models might be tough and in some cases might be less profitable than traditional bricks 'n mortar channels. But, that does not imply that these economic challenges cannot be overcome.
The additional Ecommerce Improved scenario below illustrates the amplified margin outcome when, even what might be considered modest, improvements in ecommerce and DTC drivers are pursued over time.
To improve Sales Contribution, a brand could consider targeted improvements in some or most of the following key ecommerce and DTC profitability drivers:
Unique multi-packs for ecommerce channels.
Incremental price gains to support pack uniqueness.
Paid vs. free shipping thresholds to incentivize larger orders.
Use of PPC/SEO services to improve conversions.
Optimized discount approaches to incentivize larger orders.
Packaging formats to reduce volume/weight characteristics.
Ongoing Amazon vs 3PL vs self-fulfillment reviews.
Disciplined geographic roll-out to support ad and logistics $ constraints.
For the Ecommerce Improved scenario, a multitude of the key drivers above were targeted. For example, modest changes were made to conversions rates, organic vs paid conversions, cost-per click, ecommerce-optimized packaging, logistics costs, strategic discounting and unique pack pricing.
The total Dollar amounts have increased because the sales volumes have increased. Optimization implies that some unit costs will increase but others will decrease. It is the net effect and impact that matters.
Sales Contribution Dollars increased more than four-fold from $74,000 to $330,000 when comparing the Ecommerce Reality and the Ecommerce Improved scenario. Sales Contribution % of Net Sales increased from 10% to 24%, while Sales Contribution per consumption unit increased by 2.8X from $0.34 to $0.95 per consumption unit.
To some extent, the magnitude of the illustrative scenario numbers are irrelevant. What is relevant is that all brands can analyze, plan and monitor pragmatic ecommerce margin improvement plans if they adopt a bottom-up unit economics and driver approach.
This is probably a good time to ask yourself whether the growth plan for your brand and SKUs for both bricks 'n mortar and ecommerce channels is underpinned by credible and achievable unit economic realities!
The (sales contribution) bottom line
Traditional gross margin definitions and measures are sometimes distorted and misused given that they are subject to cost allocation decisions that can vary with respect to whether those costs are "expensed" before or after the net sales and gross profit line. This has occurred in bricks 'n mortar business channels and is increasingly cropping up in ecommerce and DTC channels.
Just like for bricks 'n mortar channels, where there is a preferred and recommended approach to defining gross margin within CPG and consumer goods categories, the industries need to start converging on common management accounting approaches for ecommerce and DTC. Hopefully, this article adds a voice and a small stimulus to that discussion.
Yet, the construct for gross profit or gross margin has itself evolved. Many, many decades ago, defining gross margin was relatively easy. Marketing expenses, the lion's share being large traditional ads via television, radio and out-of-home (billboards etc.), were expensed (and still are) under the SG&A overhead bucket. Trade marketing expenses, directly linked to sales outcomes, crept in later and the bridge between Gross Sales and Net Sales widened.
COGS too has changed. There was a time when the definition encompassed mostly direct variable material, packaging and own-manufacturing labor costs. Nowadays COGS can include variable and semi-variable costs as well as insourced and outsourced manufacturing and inbound logistics services. It can get complicated. Sales expenses are no different.
Sales Contribution, in Dollars and as a percentage of net sales, if measured correctly provides a powerful window into the financial and operational performance of a brand and SKU.
Elevating and tracking Sales Contribution also helps to overcome distortions and allocation "games" sometimes used with Gross Margin. Sales Contribution per consumption unit or per selling unit is extremely useful in cutting through the margin % clutter and potential anomalies when comparing profitability performance between channels whose business and go-to-market models are significantly different.
Measuring Sales Contribution correctly is critical when having to make trade-off decisions for brands and SKUs across different channels. Sales Contribution is the new Gross Margin.
Curious about how the scenarios were constructed?
These examples were derived using Margin Velocity Planner's "bottom-up" growth scenario capability to simulate and model the various outcomes.
For the Bricks 'n Mortar P&L, pragmatic velocity rates, distribution reach, COGS and logistic unit costs were used.
For the Ecommerce P&Ls, the outcomes were modeled using scenarios based on Amazon FBA fulfillment cost criteria and by using relevant order conversion rates, cost-per-click and price per mille data.
The financial data shown in all the P&Ls are rounded and represent sales and costs in a single period.
The new growth-modeling service version of Margin Velocity Planner ™ allows you to now build and integrate growth plans for Bricks 'n Mortar as well as Ecommerce channels.
Need help in analyzing and constructing a credible growth plan ? Send a message to arrange a free initial discussion.