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 in measuring that how efficiently the company is handling its production and maintaining the low levels of the variable costs whereas Gross margin formula is used to know the financial health and the performance of the company and is calculated by dividing the gross profit of the 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.
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. divided by the revenue. The cost of goods sold includes only the production costs, i.e., the fixed costs and the variable product costs.
- 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. 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. 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. 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..
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. 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. and not fixed costs, which are associated with production.
- Contribution Margin also helps in analyzing 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 a greater amount of sale of each product goes 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..
- Fixed costs remain the same irrespective of the sale numbers of the company. For example, rent, fixed salaries of the employees, taxes. Variable costs, however, are directly proportional to sales. It increases when sales rise and vice versa. Examples of variable costs are sales commissions, which are directly linked to sales volume.
A company had Net Sales of $450,000 during the year 2016. The inventory of goods was of the same quantity at the beginning and at the end of the year. Its Cost of Goods Sold consisted of $130,000 of variable costs and $200,000 of fixed costs. Its selling and administrative expenses were $30,000 of variable and $150,000 of 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% 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
|Basis of Comparison||Gross Margin||Contribution Margin|
|Meaning||It is the sales minus the cost of goods sold.||It is the sales price minus the total variable costs, where direct costsDirect CostsDirect costs are costs incurred by an organization while performing its core business activity and can be attributed directly in the production cost, such as raw material costs, wages paid to factory staff, power & fuel expenses in a factory, and so on, but do not include indirect costs such as advertisement costs, administrative costs, etc. include material, labor, and overheads.|
|Importance||It 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. may not be profitable.|
|Formulae||= (Revenue – COGS)/Revenue||= (Sales – Variable Costs) / Sales|
|In terms of profitability metric||It is useful for analyzing the total profit metric.||It is used for analyzing the per item profit metric.|
|Consideration of Variable cost and Fixed cost||It includes both fixed and variable costs associated with the production of the goods during the calculation.||It includes only variable costs during the calculation.|
|Application||It is used for historical calculations or projections with specific sales value.||It is useful for multiple scenario analysis.|
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, to analyze the marketing campaign which was most profitable, and optimization of the product price. Gross Margin indicates the profitability of the company, 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. have the edge over their other competitors in the industry. Similarly, companies with a high contribution margin can cover the cost of producing the goods and still leave a margin of profit. 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.
This has been a guide to Contribution Margin vs. Gross Margin. Here we discuss the top differences between gross and contribution margin along with the example, infographics, and comparison table. You may also have a look at the following articles –