Contribution Margin

What is the contribution margin?

Contribution margin (in German, Deckungsbeitrag) refers to the amount that remains from revenue after deducting variable costs. Variable costs arise additionally with every unit sold, for example for material, shipping or payment fees. The remaining amount contributes to covering the fixed costs, that is, the costs that arise regardless of volume, such as rent and salaries; what is left after that is profit. If a subscription costs EUR 100 a month and causes EUR 20 of server and payment costs, the contribution margin is EUR 80. Relating to a single item, it is called the unit contribution margin, and for subscriptions the contribution margin per customer. Set in relation to revenue, it is called the contribution margin ratio, in the example 80%.

The term comes from marginal costing (Teilkostenrechnung), a method of internal cost accounting that separates costs according to whether they change with volume. In German controlling, the term Deckungsbeitrag is usual; contribution margin means the same. As a measure of internal accounting, it is defined neither in the German Commercial Code (Handelsgesetzbuch, HGB) nor in IFRS. It is nevertheless needed for the financial model, for pricing decisions and for investor documents, because it shows whether additional revenue improves the result. In due diligence, it is derived anew from the booking data.

Calculating the contribution margin: formulas

Formula: Contribution margin = revenue − variable costs; per item: unit contribution margin = price per unit − variable costs per unit

Formula: Contribution margin ratio = contribution margin / revenue × 100%

Variable are all costs that arise additionally with the next unit sold or the next customer. For software, these include infrastructure and server costs, payment fees, usage-based licences for integrated services and the part of customer support that grows with the number of customers. In retail and consumer goods, cost of goods, packaging, shipping and returns are added. The price actually achieved after discounts and credit notes is used, not the list price.

The separation of fixed and variable costs is rarely sharp in practice. Many costs are step-fixed: they remain constant over a range of volume and then rise in one step, for example when a further position in customer support becomes necessary above a certain number of customers. For decisions about additional volumes, such costs are often treated as approximately variable.

Contribution margin 1, 2 and 3: multi-level contribution margin accounting

Multi-level contribution margin accounting deducts from revenue, step by step, costs that can be assigned to ever larger reference objects. In the common form, this gives:

• Contribution margin I: revenue minus the variable costs of a product
• Contribution margin II: contribution margin I minus product-fixed costs, such as the development team or product marketing of a product
• Contribution margin III: contribution margin II minus fixed costs of a product group or a division
• Operating result: sum of the contribution margins III minus company-fixed costs such as management, administration and rent

The levels show which unit bears which costs. Overheads that serve several products at once are not allocated by a flat measure (allocation key) such as the share of revenue, but are deducted only at the level to which they belong. In online retail and for consumer goods brands, a different tiering is common, which is organised by cost of goods, by logistics and payment costs, and by marketing costs. Because the names are not uniform, every comparison must state which costs a level contains.

Importance for pricing and growth decisions

Price floors and discounts

In the short term, the price floor lies at the variable costs. Every order with a positive contribution margin then improves the result, as long as free capacity exists and no fixed costs are added. In the long term, prices must also cover the fixed costs. How strongly a discount takes effect depends on the contribution margin ratio: the lower it is, the more additional volume is needed to compensate for a price reduction.

Product range and growth

A product with a positive contribution margin I can be negative at the second level if its own fixed costs are assigned to it. Whether discontinuing it improves the result depends on which of these costs can actually be reduced and whether the product supports the sales of other products. For growth, the following applies: only with a positive contribution margin per unit does rising volume cover a growing part of the fixed costs. If it is negative, every additional unit increases the loss.

Contribution margin in valuation and due diligence

Investors read from the contribution margin ratio how much additional revenue contributes to the result. It also shows how well a business model can grow without costs rising to the same extent (scalability). With revenue multiples (revenue multiple), it explains part of the differences between companies with similar growth. With a high ratio, a larger share of every additional euro of revenue reaches the result. How strongly the result reacts in percentage terms to a change in revenue is described by operating leverage, the ratio of contribution margin to operating result.

The income statement under the nature of expense method is organised by types of cost such as material, personnel and other expenses, and does not separate fixed and variable costs. Customer support appears in personnel expenses, server costs in other operating expenses. Reviewers therefore reassign these items and compare the ratio with the presentation in the financial model. Deviations between the two are a frequent reason for follow-up questions.

Worked example: contribution margin per product and effect of a discount

A software company offers core software and an add-on module with a hardware component. The figures for the last financial year:

• Core software: revenue EUR 6.0 million, variable costs EUR 1.5 million, contribution margin I EUR 4.5 million (ratio 4.5 / 6.0 = 75%); product-fixed costs EUR 1.5 million, contribution margin II EUR 3.0 million
• Add-on module: revenue EUR 2.0 million, variable costs EUR 1.2 million, contribution margin I EUR 0.8 million (ratio 0.8 / 2.0 = 40%); product-fixed costs EUR 1.0 million, contribution margin II minus EUR 0.2 million
• Sum of the contribution margins II: 3.0 minus 0.2 = EUR 2.8 million; company-fixed costs EUR 2.4 million; operating result EUR 0.4 million
• Discontinuing the module if all product-fixed costs fall away: operating result 3.0 minus 2.4 = EUR 0.6 million
• Discontinuing if only EUR 0.5 million of the product-fixed costs can be reduced: 0.4 minus 0.8 plus 0.5 = EUR 0.1 million
• Discount of 10% on the core software: the contribution margin per EUR 100 of previous revenue falls from EUR 75 to EUR 65; required volume growth 75 / 65 = 1.154, that is, 15.4%
• The same discount on the add-on module: fall from EUR 40 to EUR 30; required volume growth 40 / 30 = 1.333, that is, 33.3%

The negative contribution margin II of the module does not by itself justify discontinuing it. What matters is which costs actually fall away and whether customers also buy the core software without the module. The discount calculation shows why price reductions are particularly expensive with a low ratio: at 40%, volume has to rise by a third to compensate for a discount of 10%.

Distinctions: contribution margin, gross profit and gross margin

• Gross profit (Rohertrag): revenue minus cost of materials or goods, as shown for example in the business management evaluation (Betriebswirtschaftliche Auswertung, BWA). It is an approximation of contribution margin I but does not capture other variable costs such as payment fees or commissions.
• Gross margin: deducts from revenue the cost of sales, that is, the costs incurred directly for the services sold. It is a measure of the income statement, the contribution margin a measure of cost accounting.
• Fixed and variable costs: the classification of costs by their behaviour, on which every contribution margin calculation rests, including step-fixed costs and mixed costs.
• Unit economics: link the contribution margin per customer with acquisition costs and customer lifetime.
• Break-even: the point at which the contribution margins in total just cover the fixed costs. It follows directly from the contribution margin and the fixed cost block.

Common mistakes

• Costs ordered by type instead of behaviour. Customer support that grows with the number of customers is variable, even if it is booked in personnel expenses.
• List prices instead of prices achieved. Discounts, credit notes and bad debts reduce the contribution margin and are missing in calculations based on the price list.
• Only the overall average. Individual products, tariffs or customer groups can be negative without this showing in the average.
• Fixed costs allocated by keys. If administration is allocated proportionally to products, profitable products appear loss-making. Decisions on this basis worsen the result if the allocated costs do not fall away.
• Levels not defined. One company's contribution margin II often does not correspond to another's. Without a definition, comparisons are not meaningful.

Frequently asked questions

What is the difference between contribution margin and gross margin?

The gross margin deducts the cost of sales from revenue, the contribution margin all variable costs and no fixed ones. Cost of sales are the costs incurred directly for the services sold; they often also contain fixed parts, such as a permanently employed support team. Conversely, they often lack variable sales costs such as revenue-based commissions. Depending on the cost structure, the contribution margin is therefore above or below the gross profit; for software, the two are often close together.

What is a good contribution margin ratio for software?

As a rule of thumb, pure software products reach 70% to 85%. Hardware, logistics or labour-intensive services lower the ratio noticeably. More important than the industry comparison is the question whether the contribution margin carries fixed costs and customer acquisition.

How is the contribution margin calculated for subscriptions?

Usually per customer and month: monthly revenue after discounts minus the variable costs that the customer causes on an ongoing basis. One-off set-up costs and sales commissions are often recorded separately, because they count as acquisition costs and go into the unit economics.

May a product with a negative contribution margin stay on offer?

Only with a particular reason. If contribution margin I is already negative, every unit sold costs money, and more sales increase the loss. This is defensible at most for a limited time, for example with an introductory offer that demonstrably leads to profitable follow-on revenue.

The Roemer Capital view

In the financial models we build for funding rounds and sale processes, we show the contribution margin separately by product, tariff and customer segment and reconcile it to the accounting. We agree the allocation of costs with the management before investors see the figures, so that due diligence finds the same calculation.

If an offer with a negative contribution margin shows up, this is first of all a basis for decision: price adjustment, discontinuation or justified continuation can be decided before the round. If the same finding becomes visible only in an investor's review, it shifts the discussion from pricing to valuation.