What is Gross Margin and Contribution Margin?
Short Answer
Gross Margin = (Revenue − Cost of Goods Sold) / Revenue. Contribution Margin = (Revenue − Variable Costs) / Revenue. Both measure profitability at different levels of cost allocation.
Full Explanation
Gross Margin shows the percentage of revenue remaining after covering direct product costs (materials, labour directly tied to production). For a SaaS company with £1M revenue and £200K COGS (cloud infrastructure, payment processing), Gross Margin = £800K / £1M = 80%. Typical SaaS gross margins are 70-90%. Contribution Margin includes variable costs beyond COGS (e.g., payment processing, customer support, hosting). If £200K COGS + £150K variable support = £350K variable costs, Contribution Margin = £650K / £1M = 65%. Contribution Margin is more realistic for unit economics: it shows the profit after all variable costs, available to cover fixed costs (salaries, rent, marketing). For LTV calculations, contribution margin (not gross margin) should be used: if a customer generates £10K annual revenue with 65% contribution margin = £6.5K available to cover CAC and other fixed costs. Fixed costs (headcount, facilities) don't change with customer count, so don't affect per-unit economics. Understanding the difference is critical: high gross margin (80%) with low contribution margin (40%) suggests significant variable cost per customer — unit economics may not work at scale.
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