Gross profit margin measures the amount of revenue that remains after subtracting costs directly associated with production. Contribution margin is a measure of the profitability of various individual products.
Gross margin is synonymous with gross profit margin and only includes revenue and direct production costs. It does not include operating expenses such as salaries, advertising, or other company expenses such as taxes or interest on loans. For example, gross margin would include the costs for a factory's direct labor and direct materials, but not the administrative costs for operating the corporate office.
The direct production costs are called cost of goods sold (COGS). Cost of goods sold is the cost to produce the goods or services that a company sells. Gross margin shows how well a company generates revenue from the direct costs like direct labor and direct materials involved in producing their products and services.
Gross margin is calculated by deducting cost of goods sold from revenue, and dividing the result by revenue. The result can be multiplied by 100 to generate a percentage.
Gross margin example:
If total revenue for a company was $2 million and the cost of goods sold was $1.5 million, gross margin would equal:
= revenue - COGS
= $2,000,000 - $1,500,000 = $500,000
or as a percentage:
= (2,000,0000 - $1,500,000)/ 2,000,000 = .25 or 25%
Contribution margin is the revenue remaining after subtracting the variable costs involved in producing a product. Contribution margin calculates the profitability for individual items that the company manufactures and sells. Specifically, contribution margin is used to review the variable costs included in the production cost of an individual item. In comparison with gross profit margin, it is a per-item profit metric, as opposed to the total profit metric given by gross margin. Contribution margin is typically expressed as a percentage.
Contribution Margin Example
Total sales or revenue from an item that a company produces equals $10,000 while the variable costs for the item equal $6,000. Contribution margin is calculated by subtracting the variable costs from the revenue generated from sales of the item and dividing the result by revenue.
= sales - variable costs / sales
= ($10,000 - $6,000)/$10,000 = .40 or 40%
The contribution margin is not intended to be an all-encompassing measure of a company's profitability. However, the contribution margin can be used to examine variable production costs. The contribution margin can also be used to evaluate the profitability of an item and to calculate how to improve its profitability, either by reducing variable production costs or by increasing the item's price.
For more on profit margins, please read "How Do Gross Profit Margin and Operating Profit Margin Differ?"