First-time founders: What’s the difference between gross margin, contribution margin and EBITDA margin? Which one(s) should you care about?
Margin jargon can be confusing. There’s a lot of terminology. To make matters worse, two of these margins, GM and CM, aren’t well-defined.
Here’s a practical guide:
Gross margin:
- If designed well, GM is meant to answer the question: what’s my margin on the next ‘unit’ sold?
- To answer this question, best to include all purely variable costs incurred as a consequence of selling another unit of your product.
- If you’re in software, include cloud infrastructure costs, customer support and onboarding costs, amortized software development costs, and payment processing fees.
- If you’re in e-commerce, include product costs, inbound and outbound freight, and payment processing fees.
- In reality, a lot of companies play games with GM. They exclude certain variable costs to inflate it. This only limits the usefulness of this KPI as a tool to understand the business. Avoid the temptation. Include more variable costs versus less.
- What does GAAP say? GAAP has certain rules around COGS, but only for inventory. For this reason, GM can be manipulated fairly easily.
Contribution margin:
- CM is meant to answer a different question: what margin do I earn from my growth engine?
- CM should include one additional layer of costs: sales and marketing. I recommend including the costs of your sales team and performance marketing. You may exclude brand marketing, depending on how you define it and how fixed it really is.
- What does GAAP say? CM is not a GAAP concept. No accounting body defines it, no auditor checks it, and no two companies calculate it exactly the same way.
EBITDA margin:
- EM tells you how profitable your business is, including all your fixed operational costs.
- EBITDA is not a GAAP metric, but it is well-defined. The name itself is the definition: Earnings Before Interest, Taxes, Depreciation and Amortization.
- Since EM is clearly defined, it’s hard to play games with it.
- Many companies include an ‘Adjusted EBITDA’ figure, adding back non-recurring, non-cash and non-core expenses. This can be a useful way to track underlying EBITDA trends, but it’s also a great way to game the number, no surprise. If you can avoid this metric, I recommend you do.
If you’re a founder, take the time to ensure your margins are set up logically. Once your finance team has sharpened the tool, you can use it to understand your business.
→ Gross margin: is my product economically profitable
→ Contribution margin: is my growth engine working
→ EBITDA margin: am I generating profit above and beyond my fixed costs
About the Author:
Karsten Loose is co-founder and Managing Partner at Karlon Group, a fractional finance and accounting firm that helps companies build, scale, and optimize their finance and accounting functions. Karlon Group works with companies across SaaS, consumer, manufacturing, and technology, offering a full suite of finance and accounting support tailored to each client’s changing needs.