Gross Margin vs. Contribution Margin: An Overview
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 the amount of money left after subtracting direct costs, while contribution margin measures the profitability of individual products.
- Gross margin encompasses an entire company’s profitability, while contribution margin is a per-item profit metric.
- Contribution margin can be used to examine variable production costs and is usually expressed as a percentage.
- While gross profit is generally an absolute value, gross profit margin is expressed as a percentage.
Gross margin is synonymous with gross profit margin and includes only revenue and direct production costs. It does not include operating expenses such as sales and marketing expenses, or other items such as taxes or loan interest. Gross margin would include a factory's direct labor and direct materials costs, but not the administrative costs for operating the corporate office.
Direct production costs are called cost of goods sold (COGS). This is the cost to produce the goods or services that a company sells. Gross margin shows how well a company generates revenue from direct costs such as direct labor and direct materials costs. Gross margin is calculated by deducting COGS from revenue and dividing the result by revenue. The result can be multiplied by 100 to generate a percentage.
Contribution margin is the revenue remaining after subtracting the variable costs that go into producing a product. Contribution margin calculates the profitability for individual items that a company makes and sells. Specifically, contribution margin is used to review the variable costs included in the production cost of an individual item. It is a per-item profit metric, whereas gross margin is a company's total profit metric. Contribution margin is usually expressed as a percentage.
Gross Margin vs. Contribution Margin Example
If a company has $2 million in revenue and its COGS is $1.5 million, gross margin would equal revenue minus COGS, which is $500,000 or ($2 million - $1.5 million). As a percentage, the company's gross profit margin is 25%, or ($2 million - $1.5 million) / $2 million.
For an example of contribution margin, take Company XYZ, which receives $10,000 in revenue for each widget it produces, while variable costs for the widget is $6,000. The contribution margin is calculated by subtracting variable costs from revenue, then dividing the result by revenue, or (revenue - variable costs) / revenue. Thus, the contribution margin in our example is 40%, or ($10,000 - $6,000) / $10,000.
Contribution margin is not intended to be an all-encompassing measure of a company's profitability. However, contribution margin can be used to examine variable production costs. Contribution margin can also be used to evaluate the profitability of an item and calculate how to improve its profitability, either by reducing variable production costs or by increasing the item's price.