Gross Margin vs. Contribution Margin: An Overview
Gross profit margin measures the amount of revenue that remains after subtracting costs directly associated with production. The 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 is a total profit metric, encompassing an entire company’s profitability, while contribution margin is a per-item profit metric
- The contribution margin can be used to examine variable production costs.
- The contribution margin is typically expressed as a percentage, while the gross margin is generally an absolute value—the gross profit margin is expressed as a percentage.
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 the cost of goods sold (COGS). COGS is the cost to produce the goods or services that a company sells. The 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 COGS from revenue and dividing the result by revenue. The result can be multiplied by 100 to generate a percentage.
The contribution margin is the revenue remaining after subtracting the variable costs involved in producing a product. The contribution margin calculates the profitability for individual items that the company manufactures and sells. Specifically, the contribution margin is used to review the variable costs included in the production cost of an individual item. In comparison with the gross profit margin, it is a per-item profit metric, as opposed to the total profit metric given by gross margin. The contribution margin is typically expressed as a percentage.
Gross Margin vs. Contribution 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 less COGS, which is $500,000, or $2,000,000 - $1,500,000. As a percentage (gross profit margin), it’s 25%, or (2,000,0000 - $1,500,000) / 2,000,000.
As an example of contribution margin, consider total sales or revenue from an item that a company produces equals $10,000 while the variable costs for the item equal $6,000. The contribution margin is calculated by subtracting the variable costs from the revenue generated from sales of the item and dividing the result by revenue, or (sales - variable costs) / sales. Thus, the contribution margin in our example is 40%, or ($10,000 - $6,000) / $10,000.
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.