Contribution Margin vs Gross Margin

Updated on April 18, 2024
Article byPritha Banerjee
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

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.

What is Gross Margin?

We can illustrate gross margin using the below income statement:

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

income statement of company ABC

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.

Contribution Margin vs Gross Margin

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Contribution Margin Explanation in Video

 

What is the Contribution Margin?

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.

Contribution Margin vs. Gross Margin Infographics

Contribution Margin vs. Gross Margin Infographics

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Comparative Table

Basis of Comparison Gross MarginContribution Margin
MeaningIt 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) / Sales
In 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

This has been a guide to Contribution Margin vs. Gross Margin. Here we discuss the top differences between gross and contribution margin and the example, infographics, and comparison table. You may also have a look at the following articles –