Retail businesses are constantly striving to tip the scales of production costs and sale price. The less a product costs to produce, the better the company’s product margins are likely to be—providing a competitive advantage and greater profits.
A company’s product margin is how much it profits from the sale of each product. Sometimes called product markup, it’s the difference between the total cost of producing a product and the sale price. Product margin is expressed as a percentage.
Product margin is sometimes confused with profit margin. While profit margins represent how much the company pockets after all expenses—including overhead and operating expenses like employee salaries and marketing costs—product margins reflect the profitability of the goods, not the company. Product margin can be calculated for the company’s entire product mix—referred to as gross margin—or on a per-product basis.
Product margins tell an important story: they indicate how profitable the company’s actual core offering is. Even the leanest, most efficiently run company won’t survive if its product margins aren’t healthy. Calculated on a per-product basis, product margins can identify the products that bring in the most revenue, which can help inform decisions around discounting, advertising, and the discontinuation or expansion of a particular product line.
There’s no magic number when it comes to product margin, because the health of a margin is relative to an individual company’s unique products, operating costs, target demographic, and region.
For example, a company with a low average order value but high order volume—like razor blades—may have a low product margin compared to other DTC brands, but can still turn a profit because consumers need to make regular, repeated purchases. Meanwhile, a brand with a very high average order value, like a mattress company, might have a much higher product margin—but consumers will only make a repeat purchase every 5-10 years.
While the optimal product margin will vary from business to business, our research found that DTC brands that have scaled to the point of going public almost always had gross margins north of 40%. Achieving healthy product margins was a key part of those businesses’ strategies, achieved in part by streamlining their distribution and fulfillment processes.
When evaluating your product margin, consider whether your company is making enough of a profit to invest in growth. One of the most important factors of scaling is ensuring the business’ gross margins align with customer acquisition costs.
Remember, gross margin is a measure of how much the company profits from all sales after the cost of goods sold (COGS)—in other words, the product margin in aggregate, across all SKUs. This number should align with your customer acquisition costs to ensure you can invest your revenue into growing your consumer base without incurring losses.
To calculate a given product’s margin, take the sale price and deduct the total cost for producing that product—COGS per unit—and divide by the sale price.
For example: Let’s say your company sells umbrellas. It costs $3.50 to produce each umbrella, and you sell them to consumers for $7. The product margin would be 50%.
The formula is simple enough, but determining the total COGS comes with its own complexities.
COGS is the direct cost of producing an item for sale. It does not include other operating expenses like overhead, salaries, marketing, or business software.
Traditionally, COGS included only the fees associated with the company manufacturing or acquiring the product: raw materials, production, and inbound freight to the fulfillment center.
But the DTC business model isn’t traditional. Unlike the brands of yesteryear that sent massive purchase orders to a handful of retailers, direct-to-consumer brands incur fulfillment and shipping costs on a per-order basis. Fulfillment costs have an enormous impact on this business model—so, many DTC brands opt to lump those expenses into their COGS.
To fully understand their expenses, DTC brands often differentiate between product and non-product COGS. Product COGS are those traditional costs: material sourcing and manufacturing. Non-product COGS are the “indirect” costs associated with getting the product to the consumer: warehouse storage, the labor associated with preparing a package, and shipping.
Following this DTC-specific definition, COGS includes:
If your COGS includes fulfillment costs, optimizing your fulfillment operations can significantly improve product margins. Some expenses, like the cost of raw materials, have little wiggle room—but there are many other fees that can be lowered through careful planning.
Here are the five ways you can increase product margins through fulfillment:
When looking for a vendor to produce your inventory, you’ll come across many trade companies and wholesalers posing as manufacturers. These businesses act as middlemen, selling manufactured goods at a markup. You can cut costs and increase product margins by going directly to the source and developing a relationship with the factory.
Pro-tip: Look for a manufacturer that is already producing products similar to yours. They may have existing molds that you can use to make your own inventory. Producing these molds yourself can rack up thousands of dollars.
Less time spent preparing orders means lower labor costs. Dig in to your 3PL’s pick and pack processes: how long does it take, on average, to prepare and label an order?
Storing popular products close together, creating a streamlined floor plan, and having an organized packing station can go a long way in making the fulfillment center more efficient. If your provider is charging exorbitant base order or pick fees, you may want to consider looking for a new 3PL to maximize your product margin.
The expense of obtaining packaging materials is often overlooked, but a few cents per order can add up fast.
Most 3PLs provide basic packaging free of charge, but branded packaging will be paid for out of your pocket. This might be an important part of your marketing strategy, but small compromises like keeping the inside of the box plain or reducing the number of colors in your design can significantly reduce your expenses. You might also consider customizing smaller elements of the packaging, like branded wet tape, and using standard boxes.
Packaging costs—both the container your product is sold in and the box that is handled by the shipping carrier—is a major component of your product margin.
Your shipping strategy provides the most opportunities to lower expenses. There are six things to consider:
Outsourcing fulfillment means your storage fees are variable, so you only have to pay for as much storage space as you’re using at any given time.
Manage your inventory carefully to further lower your storage fees. If you store less inventory, you’ll likely reduce your dwell time (but be careful to avoid backorders). Selling fewer SKUs can also raise your product margins: If you sell just two or three unique items, most of your inventory can be stacked while it’s stored, because warehouse employees will only need to be able to access two or three pallets or storage bins at a time. Most fulfillment centers charge less to store stacked inventory.
Every element of distribution is a scale economy that benefits bigger companies with greater volume. As your business scales, your expenses per order will fall; but the challenge lies in getting to that point.
By raising your product margin, you’ll have more to invest in acquiring customers, adding sales channels, and expanding into new markets—all of which will put your company on a trajectory to reach economies of scale.