Contribution Margin vs Gross Margin

Gross margin is what accountants report. Contribution margin is what operators need.

The formulas

Gross margin = (Revenue − Cost of goods sold) ÷ Revenue

Contribution margin = (Revenue − All variable costs) ÷ Revenue

Gross margin follows accounting rules for what counts as COGS. Contribution margin follows economic logic — every cost that scales with revenue, regardless of where it sits in the income statement.

What gross margin measures

Gross margin captures the profit left after direct production costs. For a manufacturer, that’s materials and direct labour. For a software company, it’s hosting, third-party software costs, and customer support directly tied to delivery.

The number appears on every income statement and follows generally accepted accounting principles. It’s standardised, audited, and comparable across companies in the same industry.

An 80% gross margin means 80p of every pound of revenue survives to cover operating expenses and profit. A 30% gross margin means 70p goes straight to production costs. The difference determines how much room you have for everything else.

What contribution margin measures

Contribution margin asks a different question: what profit remains after all costs that vary with revenue?

This includes COGS, but also variable sales commissions, payment processing fees, usage-based software costs, customer success for onboarding, and anything else that increases when you sell more. These costs might sit in COGS, sales expense, or general overhead depending on accounting treatment — contribution margin ignores the categorisation.

A SaaS company might show 75% gross margin but only 55% contribution margin once you add sales commissions, payment processing, and the customer success team. Both numbers are true. They answer different questions.

Why the difference matters

Gross margin tells you about production economics. Contribution margin tells you about unit economics.

For scalability: Gross margin doesn’t capture whether your go-to-market costs scale efficiently. A company with 80% gross margin but 40% contribution margin needs significant volume before operating leverage kicks in. One with 80% gross and 70% contribution reaches profitability much sooner.

For pricing decisions: If you’re evaluating whether to discount, contribution margin is what matters. A 10% discount on an 80% gross margin product seems fine — still 70% gross. But if contribution margin was 50%, that same discount cuts contribution margin to 40%, a 20% reduction in the profit that actually covers fixed costs.

For customer segmentation: Some customers cost more to serve. Enterprise customers might require dedicated success managers; SMB customers might use self-service. Gross margin treats them identically if the product cost is the same. Contribution margin reveals which segments actually make money.

What gross margin hides

Cost of goods sold is an accounting category, not an economic one. Companies have discretion over what goes in.

Some companies include customer support in COGS; others put it in operating expenses. Some capitalise software development and amortise it through COGS; others expense it as R&D. These choices are legitimate but make cross-company comparison unreliable.

Gross margin also hides below-the-line variable costs. A company might report 75% gross margin while spending 20% of revenue on variable sales costs and 5% on payment processing. The headline number looks strong; the actual contribution to covering fixed costs is only 50%.

What contribution margin hides

Contribution margin requires judgement about what’s variable. Is the customer success team variable (scales with customers) or fixed (a baseline team regardless of volume)? The answer affects the calculation significantly.

It also hides the level of fixed costs. Two companies with identical contribution margins can have completely different profitability depending on their fixed cost base. High contribution margin doesn’t guarantee profit if fixed costs are higher.

The time horizon matters too. Costs that look fixed in the short term become variable over longer periods. You can’t cut your engineering team this quarter, but you can resize it over a year. Contribution margin is always a snapshot at a particular planning horizon.

Where it breaks down

Mix effects. Blended contribution margin across products or segments can mislead. A company showing 60% overall contribution margin might have one product at 80% and another at 20%. The average hides a portfolio problem.

Step functions. Some costs are semi-variable — fixed within a range, then step up. A support team might handle 1,000 customers with no additional cost, then require expansion. Contribution margin assumes smooth scaling that doesn’t exist.

Accounting inconsistency. Since contribution margin isn’t standardised, different companies calculate it differently. One might exclude sales commissions because they’re “fixed” for quota-carrying reps; another includes them. Comparisons require asking how the number was constructed.

The decision it enables

Contribution margin answers: if we sell one more unit, how much profit falls to the bottom line?

For pricing, this is the number that matters. Any price above variable cost contributes to covering fixed costs. Gross margin might suggest you need 50% markup; contribution margin might reveal you need 100%.

For customer acquisition, contribution margin determines the ceiling for CAC. If contribution margin is 60% and customer lifetime is three years, you can spend up to 180% of year-one revenue acquiring them and still break even.

For evaluating business quality, contribution margin is more honest than gross margin. It shows you the real economics of each incremental sale, not the accounting construct.

The metric series: Part of a series on metrics that reveal what headline numbers hide.