A Case for Contribution Margin: An Insightful & Underutilized Metric

The most commonly used profitability metric in the startup world is Gross Margin. Gross Margin shows how much revenue is left after all the direct expenses to generate this revenue. As companies reach profitability, they also start looking at EBITDA Margin. EBITDA shows how much revenue is left after all fixed and variable operating expenses before interest, taxes, and depreciation & amortization.?

Another metric that’s less widely used and understood is Contribution Margin.?

Contribution Margin shows you the amount of revenue available after variable costs to cover fixed expenses. As opposed to Gross Margin, this metric also captures costs incurred in selling the product and acquiring new business. The formula is quite simple:?

Contribution Profit (“CP”, $) = Revenue ? Variable Costs

Contribution Margin (“CM”, %)? =? Contribution Profit / Revenue?

Variable costs are expenses that vary with the quantity of products or services you sell. It is not difficult to calculate the metric based on your income statement.? However, every company is different and there will be nuances on a case-by-case basis. For example, certain costs included in COGS might be fixed or semi-fixed (e.g. some salaries). Before you decide what goes into your CM formula, take the time to go through your income statement with a fine comb and make decisions about certain line items.

Why does Contribution Margin matter? If your CM is negative, no scenario or scale will make your business profitable. This means you are losing money on each unit of product you sell. You will need to increase the selling price and/or reduce COGS and other variable expenses before a break-even point becomes attainable.?

What are the use cases?

• Total CM on the Company Level.? As described above, CM is a useful diagnostics tool to understand whether your business model is sustainable. Positive CM means that you have revenue in excess of variable costs left to cover your fixed expenses, meaning you are on the path to profitability as you increase scale. I find it helpful to run scenarios incorporating various assumptions on product pricing and cost dynamics to identify the optimal strategy to get to a sustainable contribution margin.
• CM by Product. ?If you have multiple products, CM is a useful tool to analyze your product portfolio. Comparing CM by product helps with several types of decisions, such as:

-Whether to add or discontinue a product or a product line.

-How to price a product or service.?

-Where to focus cost reduction efforts.?

-How to structure sales commissions.

-How to allocate resources - products with the highest CM will contribute to your bottom line the most as you scale them.

• CM by Unit. What a unit is will depend on your business model. In many cases in the tech world, your unit would be a contract or transaction. CM by unit is one of the ways to calculate your unit economics. CM will show you where you might need to rethink the pricing, revise GTM strategy, or reduce costs.?

If your business has more than one segment or BU, understanding the CM of each segment/BU will help you optimize your business portfolio for maximum overall profitability. CM can also be calculated for each channel or customer. If used consistently throughout the organization, CM could be the common denominator for major strategic decisions.?

When is it appropriate to start calculating CM?

I have heard an opinion that Contribution Margin is not appropriate for early-stage companies, as they might not have sufficient data or don’t have the budget for highly skilled finance specialists. I will respectfully disagree with this opinion. In my experience, any company which has been using Quickbooks or similar accounting software for 12+ mos and has an accountant could calculate CM as early as Round A. It may take time and could require changes to your chart of accounts, but it is worth the effort.?

Knowing your CM is ultimately knowing your unit economics, which is mandatory for understanding profitability levers and achieving a breakeven point.?