Contribution Margin vs Gross 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 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 sold 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 expenses like wages, rent.
  • Gross margin is important as it measures the preliminary profitability of a company before subtracting the overhead costs 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

Contribution Margin vs Gross Margin - Income statement
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 expenses like taxes and interest on loans. In order to avoid losses, the Gross Margin needs to be high in order to cover the operating expenses.

Contribution-Margin-vs-Gross-Margin

What is the Contribution Margin?

  • Contribution Margin 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 Margin 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 costs.
  • 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.

Example

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 Percentage 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

Gross-Margin-vs-Contribution-Margin

Comparative Table

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 costs 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 line 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.

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, 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 profit 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.

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