What are Contribution Margin and Operating Leverage?

A few weeks ago, I posted in this space about unit economics, and I stated that they are your business. While I stand by that, I want to clarify that a company’s unit economics are not the only financial metrics / KPIs that matter. Financial management is all about taking a wide array of metrics and piecing them together to get a better understanding of a business as a whole. But the tough task for entrepreneur is being able to see through financial noise and recognize what’s important and what’s not important. Before you can even get to that point, you need to start out by defining a couple of terms.

One of those terms is Contribution Margin. Contribution margin is one of those metrics that gets thrown around a lot by MBAs, investors and CFOs. So what exactly does it mean? Contribution margin represents the incremental money generated by each unit sold after deducting the variable costs of that unit. In other words, contribution margin is the sales revenue less the variable costs on a per unit basis.

So you might be asking yourself, what is a variable cost? Don’t feel like you are alone - a lot of folks don’t totally understand the difference between fixed and variable costs, especially if you are a SaaS company or some other unique technology startup. The key here is that if the cost of a line item stays constant regardless of how many units are sold, then it is a fixed cost. As such, variable costs are line items that fluctuate directly based on number of units sold. They are what actually goes into making a product, both in a physical sense and in a non-physical sense. But even then, classifications of costs can be up for debate. One common mistake with determining fixed vs. variable costs is the question of whether or not an employee who produces a unit should count as a fixed or variable cost. That all depends on whether or not that employee is paid on a per-unit sold basis - if their man-hours-paid are directly tied to the creation of the unit, then they need to be counted as a variable cost. (If a salaried employee receives a commission based on each unit sold, then their salary is a fixed cost and the commission is variable). Most variable costs are also costs of goods sold - these terms can almost be used interchangeably.

(If you are looking for a more detailed breakdown of variable costs for a software company, check out this blog from Software Equity Group.)

For a typical software / tech company, COGS usually consists of service expenses (rack space), payments for third-party software built into your own software, customer success / implementation costs, customer support teams, marketing expenses, expenses to acquire the customer, and several others. You might be thinking - “wow, that’s a lot of expenses for a startup, maybe my unit economics aren’t that great”. And what’s more, most of them are unavoidable at the outset of any tech company and are particularly robust at the start of a customer relationship. But once a customer is using the product and locked in to the product, the contribution margin for the startup increases because the dollars brought in from that customer begin to outweigh the initial costs for acquiring that customer.

But it gets a little more deeper than that because variable costs can mean different things to different people. The question we are solving for with contribution margin is the actual profitability of a product on an incremental step-function. You might read the above statement of how to calculate contribution margin (“sales revenue less the variable costs”) and jump to the same conclusion I did when first learning about this term - isn’t that just gross margin? In a sense, yes, those formulas are basically the same. The key difference for contribution margin is that it looks at this formula on a per unit basis - meaning that whoever is using it to calculate something, wants to know margin figures on a more granular level. Like most things in finance, however, it uses some pretty simple math to express a broader idea.

Contribution margin can tell you a number of things, such as how many units need to be sold to cover your fixed costs, how to develop a break-even analysis, and how to to better price your product. But it can also tell you how to calculate Operating Leverage.

Operating Leverage is a calculation that tells a company to what degree they can increase net income by increasing revenue. The formula for operating leverage is Contribution Margin divided by profit. This formula will spit out a ratio that can tell you how well a company is utilizing its fixed costs. If that ratio is something like 1.50, that means that for every 1% gain of revenue, there will be a 1.5% gain in operating income (1.0% x 1.50 = 1.5%). So when the ratio is higher than one, that’s a good thing - that means that every increase in revenue also increases operating income (duh) and and to what degree that operating income is increasing. You want operating profits to increase at a faster rate than pure revenue - that means you are probably approaching scale.

A high operating leverage implies that fixed costs are pretty high, and, as a result, you have a higher threshold to break-even. It is important to note that this is all relative to how high your variable costs are as well. So for software companies, where variable costs are pretty low, they are going to have a relatively higher break-even point, but, once they achieve that break-even point, the amount of income they bring into the business starts to accrue immensely. This is not always the case - fixed costs can go up when business starts to build out and expand. As a company gets bigger and approaches “scale”, they need more and more infrastructure to keep the business going. The product needs more engineers to maintain and develop the product, administrative functions become more and more important with new people, and other capital infusions build on top of each other. So operating leverage is important, but it does change over time and it can be deceiving.

Understanding fixed costs’ marginal productivity can be important for software companies because it’s important to try and measure if the increase in fixed costs over time has been an effective use of capital and to what degree. As a company grows and spends more money on employees and other infrastructure, it’s tough to tell if that growth has been directed appropriately. Contribution Margin is just one way to tell if the capital invested into certain areas of the business is effective. For startups, this is just one piece of the toolkit for measuring the health of a companies growth. Operating leverage does not have to be great for software startups, but it should be understandable. Like most financial metrics, it’s a good way to help tell your story.

If you are looking for some more detail on contribution margin, I highly recommend this post: https://www.wallstreetmojo.com/operating-leverage/

If you are looking for some more detail on operating leverage, I highly recommend this post: https://www.wallstreetmojo.com/operating-leverage/