A note before you read: Agencies define these terms slightly differently, and there's no single official definition of contribution margin. What matters most is that you pick one definition, write it down and use it the same way every month.
First, fix the top line: net revenue
Before either margin means anything, take out pass-through costs. If you bill a client $50,000 and $20,000 of that is ad spend, printing or a subcontractor you simply pass along, your agency's real revenue is $30,000. Many agencies call this net revenue, or agency gross income.
Measure margins on gross billings and a media-heavy client looks far less profitable than a pure-service client, even when the team effort is identical. Measure on net revenue and you compare like with like.
In the books, that means pass-through costs have their own accounts, separate from your delivery costs. See our chart of accounts for agencies.
The two margins in plain language
Gross margin = (net revenue − direct delivery costs) ÷ net revenue. Direct delivery costs are mainly the people doing the client work: the share of salaries, payroll costs and benefits for time spent on delivery, plus freelancers and contractors who do delivery work.
Contribution margin = (net revenue − all variable, client-specific costs) ÷ net revenue. That's the delivery costs above, plus anything else you'd stop paying if the client left: tools and licenses bought for that client, sales commissions on the account, account management and project management time, client travel and similar.
What's left after contribution margin is what that client contributes toward your fixed overhead (rent, leadership, finance, admin, your own marketing) and profit.
Side by side
| Gross margin | Contribution margin | |
|---|---|---|
| Subtracts | Direct delivery costs | Delivery costs plus all other client-specific variable costs |
| Answers | "Does our delivery model make money?" | "Does this client pay its way and help cover overhead?" |
| Best used | Agency-wide and by service line | By client and by project |
| Typical owner | Operations and delivery leads | Owner, finance and account leads |
| Common mistake | Measured on gross billings, with pass-throughs left in | Leaving out account management time |
For the difference between gross margin and the bottom line, see gross margin vs net margin.
A worked example: two clients, one surprise
Round, made-up numbers for one month.
| Client A | Client B | |
|---|---|---|
| Billed to client | $40,000 | $25,000 |
| Pass-through costs (ad spend, printing) | −$15,000 | $0 |
| Net revenue | $25,000 | $25,000 |
| Delivery team and freelancers | −$11,000 | −$10,000 |
| Gross margin | $14,000 (56%) | $15,000 (60%) |
| Account management time | −$2,000 | −$6,000 |
| Client-specific tools | −$500 | −$1,500 |
| Sales commission on the account | −$1,000 | −$1,000 |
| Contribution margin | $10,500 (42%) | $6,500 (26%) |
On gross margin, Client B looks slightly better. On contribution margin, Client A contributes $4,000 more a month toward overhead. Client B's heavy account management and extra tools are the difference, and they'd never show up in gross margin alone.
That's the decision gross margin can't make for you: whether to reprice Client B, change how you serve them, or let them go. More on using these numbers in pricing: pricing for profit.
How to set up your books to see this
- Separate pass-through costs into their own expense or cost accounts, so net revenue is easy to calculate.
- Split delivery costs from overhead in the chart of accounts. Delivery salaries and freelancers sit in cost of services; leadership and admin sit in operating expenses.
- Track time by client and role. Without time data, you can't allocate people costs to clients. Your time-tracking tool is the source, and payroll gives the cost per hour.
- Tag revenue and direct costs by client in your accounting software, using projects, customers or classes. See QuickBooks classes vs locations.
- Allocate people costs monthly at the close, using the time data, with one documented method you don't change month to month.
- Report by client every month, alongside the agency-wide P&L. See agency accounting: profit by client and monthly financial reporting.
Software that makes this easier: best accounting software for agencies.
Mistakes we see most often
- Leaving pass-throughs in revenue, which makes media-heavy clients look worse than they are.
- Counting only freelancers as delivery cost, while salaried staff sit in overhead. The margin looks great and means nothing.
- Ignoring account management time, the most common reason a "profitable" client isn't.
- Changing the allocation method every quarter, so trends can't be trusted.
- Looking at margins quarterly or yearly only. Monthly, by client, is where problems show up early enough to act.
Where this fits with your other numbers
Contribution margin by client feeds your agency-wide gross margin, then operating profit, then net income. Lenders and buyers will also ask about EBITDA: see EBITDA vs net income. And for the full KPI set, see financial KPIs for small business.
Keep reading
- Agency accounting: profit by client
- Chart of accounts for agencies
- Best bookkeeping services for agencies
Sources
No outside sources are cited on this page: the definitions are standard management accounting, and the example numbers are made up for illustration. Benchmarks vary widely by source, so we haven't quoted any.
Questions owners ask
What's the difference between contribution margin and gross margin?
Gross margin subtracts direct delivery costs. Contribution margin also subtracts every other cost that varies with a specific client, such as account management time, client tools and commissions.
Which margin should an agency track?
Both. Gross margin shows whether your delivery model works. Contribution margin shows which clients actually pay their way.
Should pass-through costs be included in revenue?
For margin analysis, no. Measure margins on net revenue, after ad spend and other pass-throughs, so clients are compared fairly.
How do I calculate contribution margin by client?
Start with the client's net revenue, subtract the cost of delivery time and freelancers, then subtract other client-specific costs. Divide what's left by net revenue.
Do I need time tracking for this?
Yes, in practice. Time by client and role is how people costs get allocated to clients, and people are most of an agency's cost.
Want to see profit by client every month?
ABFI sets up agency books for net revenue and client margins, and closes them monthly. Start with a complimentary Business Accounting Diagnostic.