Software Growth

Contribution margin

Contribution margin is revenue minus all variable costs. It shows how much each sale adds toward your fixed costs and profit.

Contribution margin is what is left from revenue after you subtract every cost that rises and falls with sales. The remainder "contributes" to paying fixed costs like salaries and rent, and anything beyond that is profit. It is the number to use when you want to know whether selling one more subscription helps or hurts.

The a16z guide to startup metrics defines it as revenue from a customer minus the variable costs associated with that customer, and notes that variable costs include selling, administrative and operational costs tied to the customer.

How to calculate contribution margin

Example: a product earns $20,000 in a month. Variable costs are $5,000 of hosting, support and card fees (the items in COGS), plus $1,500 of affiliate commissions that scale with sales.

Your gross margin was 75%, but after commissions the contribution margin is 67.5%.

Contribution margin versus gross margin

People use the terms loosely, and for a pure software business the two are close. The difference is scope. Gross margin counts costs of delivering the product. Contribution margin counts every variable cost, so it also includes things like sales commissions, payment fees on top of delivery, and per-customer onboarding labor that does not sit in COGS. If you pay no commissions and keep all variable costs in COGS, they are identical.

Why founders use it

  • Break-even. Fixed costs divided by contribution per customer gives the customers you need. See break-even point.
  • Pricing and discounting. If a discount drops contribution below zero, the deal loses money.
  • Channel choice. A channel with a 20% partner fee has a lower contribution margin than direct sales.
  • Per-customer view. a16z uses the contribution margin to calculate customer lifetime value, which is part of your unit economics.

Per customer example

A customer pays $50 per month. Variable cost for that customer is $12.50 (hosting, support share, fees, commission). Contribution is $37.50, or 75%.

Mistakes

  • Treating salaries as variable when they really are fixed, or hiding support staff as fixed to inflate the number.
  • Ignoring usage-based costs that scale with heavy users, such as AI calls or storage.
  • Comparing your contribution margin with someone's gross margin. Check definitions before comparing.

Using it to price a discount

Say a customer asks for 40% off a $50 plan. At $30 the variable cost of $12.50 still leaves $17.50 of contribution, so the deal adds money toward fixed costs, but it also sets a precedent and lowers the average. If the same discount took the price to $12, you would lose money on every month of service. Contribution margin gives you the floor for any negotiation, and it keeps you honest about which deals are worth chasing and which only add cost.

Sources

Back to the SaaS glossary