What is the difference between contribution margin and gross profit margin?

The key difference between Contribution Margin and Gross margin is that Contribution margin is the difference between total sales by the company and its total variable cost, which helps measure how efficiently the company is handling its production and maintaining the low levels of the variable costs. In contrast, the Gross margin formula is used to know the company’s financial health and performance and is calculated by dividing the gross profit by its net sales.

Differences Between Contribution and Gross Margin

Gross Margin indicates the profitability of the company, whereas contribution indicates profit contributed by each of the products of the company.

Table of contents

• Differences Between Contribution and Gross Margin
  • What is Gross Margin?
  • What is the Contribution Margin?
  • Example
  • Contribution Margin vs. Gross Margin Infographics
  • Comparative Table
  • Final Thoughts
  • Recommended Articles

What is Gross Margin?

• Gross margin is revenue minus the cost of goods soldCost Of Goods SoldThe Cost of Goods Sold (COGS) is the cumulative total of direct costs incurred for the goods or services sold, including direct expenses like raw material, direct labour cost and other direct costs. However, it excludes all the indirect expenses incurred by the company. read more divided by the revenue. The cost of goods sold includes only the production costs, i.e., the fixed costs and the variable product costsProduct CostsProduct cost refers to all those costs which are incurred by the company in order to create the product of the company or deliver the services to the customers and the same is shown in the financial statement of the company for the period in which they become the part of the cost of the goods that are sold by the company.read more.
• Cost of goods sold is very specific as it includes only those expenses which are directly associated with the production of the good. It doesn’t include other administrative expensesAdministrative ExpensesAdministrative expenses are indirect costs incurred by a business that are not directly related to the manufacturing, production, or sale of goods or services provided, but are necessary for the smooth functioning of business operations, such as information technology, finance & accounts.read more like wages, rent.
• Gross margin is important as it measures the preliminary profitability of a company before subtracting the overhead costsOverhead CostsOverhead cost are those cost that is not related directly on the production activity and are therefore considered as indirect costs that have to be paid even if there is no production. Examples include rent payable, utilities payable, insurance payable, salaries payable to office staff, office supplies, etc.read more and subsequently calculating the operating income and net income.

We can illustrate gross margin using the below income statement:

The income statement of company ABC for the year ended December 2017

Therefore gross profit/gross margin is the first step to analyze the initial amount of sales before we deduct the other operating expenses like advertising and other expensesOther ExpensesOther expenses comprise all the non-operating costs incurred for the supporting business operations. Such payments like rent, insurance and taxes have no direct connection with the mainstream business activities.read more like taxes and interest on loans. In order to avoid losses, the Gross Margin needs to be high in order to cover the operating expensesOperating ExpensesOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit.read more.

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Source: Contribution Margin vs Gross Margin (wallstreetmojo.com)

What is the Contribution Margin?

• Contribution MarginContribution MarginThe contribution margin is a metric that shows how much a company's net sales contribute to fixed expenses and net profit after covering the variable expenses. As a result, we deduct the total variable expenses from the net sales when computing the contribution.read more is the product sale price minus the variable cost per product. Contribution Margin takes into account the individual profit of each product. Only variable costs are used to calculate Contribution MarginCalculate Contribution MarginUnit Contribution Margin is the amount you get after removing the variable costs related to the sale of a unit from its total sales. It measures the contribution of a specific product to the Company’s overall profit. read more and not fixed costs, which are associated with production.
• Contribution Margin also helps analyze the breakeven point of sales, i.e., the point at which we can generate profits. The greater the contribution margin, the more quickly we can generate profits as more sales of each product go towards the coverage of fixed costsFixed CostsFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity.read more.
• Fixed costs remain the same irrespective of the sales numbers of the company. For example, rent, fixed salaries of the employees, and taxes. Variable costs, however, are directly proportional to sales. It increases when sales rise and vice versa. Examples of variable costs are sales commissionsSales CommissionsSales commission is a monetary reward awarded by companies to the sales reps who have managed to achieve their sales target. It is an incentive geared towards producing more sales and rewarding the performers while simultaneously recognizing their efforts. A sales commission agreement is signed to agree on the terms and conditions set for eligibility to earn a commission.read more, which are directly linked to sales volume.

Example

A company had Net Sales of $450,000 during the year 2016. The goods inventory was of the same quantity at the beginning and the end of the year. Its Cost of Goods Sold consisted of $130,000 in variable costs and $200,000 in fixed costs. Its selling and administrative expenses were $30,000 for variables and $150,000 for fixed expenses.

• The company’s Gross Margin is: Net Sales of $450,000 minus its Cost of Goods Sold of $330,000 (COGS: $130,000 + $200,000) for a Gross Profit of $120,000 ($450,000 – $330,000). The Gross Margin or Gross Profit PercentageGross Margin Or Gross Profit PercentageGross profit percentage is used by the management, investors, and financial analysts to know the economic health and profitability of the company after accounting for the cost of sales. Gross profit percentage formula = Gross profit / Total sales * 100% read more is the Gross Profit of $120,000 divided by $450,000 (net sales), or 26.66%.
• The company’s Contribution Margin is: Net Sales of $450,000 minus the variable product costs of $130,000 and the variable expenses of $30,000 for a Contribution Margin of ($450,000-130,000-30,000) = $290,000. The Contribution Margin Ratio is 64.4% ($290,000 divided by $450,000).

Contribution Margin vs. Gross Margin Infographics

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Source: Contribution Margin vs Gross Margin (wallstreetmojo.com)

Comparative Table

Basis of Comparison Gross MarginContribution MarginMeaningIt is the sales minus the cost of goods sold.It is the sales price minus the total variable costs, where direct costsDirect CostsDirect cost refers to the cost of operating core business activity—production costs, raw material cost, and wages paid to factory staff. Such costs can be determined by identifying the expenditure on cost objects.read more include material, labor, and overheads.ImportanceIt indicates whether the sales are enough to cover the costs of production.It is used for pricing decisions. Low or negative contribution margins indicate that the product lineThe Product LineProduct Line refers to the collection of related products that are marketed under a single brand, which may be the flagship brand for the concerned company. Typically, companies extend their product offerings by adding new variants to the existing products with the expectation that the existing consumers will buy products from the brands that they are already purchasing.read more may not be profitable.Formulae= (Revenue – COGS)/Revenue= (Sales – Variable Costs) / SalesIn terms of profitability metricIt is useful for analyzing the total profit metric.It is used for analyzing the per item profit metric.Consideration of Variable cost and Fixed costIt includes both fixed and variable costs associated with the production of the goods during the calculation.It includes only variable costs during the calculation.ApplicationIt is used for historical calculations or projections with specific sales value.It is useful for multiple scenario analysis.

Final Thoughts

Both these margins are important profitability ratios. The ratios allow us to make decisions to increase profit by analyzing different factors such as choosing the best product line to invest in, analyzing the most profitable marketing campaign, and optimizing the product price. Gross Margin indicates the company’s profitability, whereas contribution indicates profit contributed by each of the products of the company.

Companies with high gross profitGross ProfitGross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc. from the direct income generated from the sale of its goods and services.read more have the edge over their other competitors. Similarly, companies with a high contribution margin can cover the cost of producing the goods and still leave a profit margin. But contribution margin should be compared across as it largely depends on the type of industry as some industries may have more fixed costs to cover than the others

Recommended Articles

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