Contribution margin is revenue minus variable cost. It represents the amount each sale 'contributes' toward covering fixed costs — and toward profit once fixed costs are recovered.
Contribution margin can be calculated per unit (unit selling price − unit variable cost) or in aggregate (total revenue − total variable costs). The contribution margin ratio is contribution margin / revenue, expressed as a percentage. Contribution margin is the engine of break-even analysis. Break-even volume = fixed costs / contribution margin per unit. Break-even revenue = fixed costs / contribution margin ratio. Above break-even, every additional unit of contribution margin flows directly to operating profit. The concept isolates the economics of individual products, services, or customer segments. A business with multiple product lines may find that Product A has a 65% contribution margin while Product B has 20%. Shifting sales mix toward Product A improves aggregate profitability without changing fixed costs. Lenders and analysts use contribution margin to assess the business's ability to absorb new fixed costs (like debt service). Contribution margin is not the same as gross margin. Gross margin (per GAAP income statements) typically deducts COGS, which includes some fixed manufacturing overhead allocated to cost of goods sold. Contribution margin is a management accounting concept that strictly separates variable and fixed components.
No. Gross margin deducts COGS (which includes both variable and fixed manufacturing overhead under absorption costing). Contribution margin deducts only variable costs. Contribution margin is always higher than or equal to gross margin. The difference is the fixed overhead allocated to COGS. For service businesses with no inventory, they may be close.
It depends heavily on the industry. Software and SaaS: 70–85%+. Professional services: 50–70%. Food service: 55–70% (before fixed overhead). Retail: 20–45%. Manufacturing: 30–60%. There's no universal 'good' — compare against industry benchmarks and assess whether the ratio covers fixed costs at your current revenue level.
Lenders use contribution margin (explicitly or implicitly) to model stress scenarios. If revenue drops 20%, how much does operating income change? A business with a 70% contribution margin and $200K in fixed costs will see operating income fall by $140K on a $200K revenue decline. A business with a 30% contribution margin will see a $60K fall. Lenders prefer higher contribution margins for the same fixed-cost base because of this resilience.