Contribution Margin vs Gross Margin

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

• 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

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 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 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 costs.
• 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 commissions, which are directly linked to sales volume.

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 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).

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 profit 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 –

• Contribution Margin Income Statement Format
• Marginal Costing vs Absorption Costing Differences
• Operating Profit Margin Formula
• EBIDTA Margin