Gross Margin vs. Contribution Margin: An Overview
Gross 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 based on the variable costs associated with those goods.
- Gross margin is the amount of profit left after subtracting the cost of goods sold from revenue, while contribution margin is the amount of profit left after subtracting variable costs from revenue.
- Gross margin encompasses an entire company’s profitability, while contribution margin is more useful on 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.
- Contribution margin is used to determine the breakeven point, while gross margin is more likely to be used to set operating targets for divisions to achieve.
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.
How to Calculate Gross Margin
Gross profit is calculated as the different between net sales and cost of goods sold. Gross profit margin is calculated as the ratio between gross profit and net sales:
Gross Profit Margin=Net SalesNet Sales−COGSwhere:COGS=Cost of goods sold
Net sales is determined by taking total gross revenue and deducting residual sale activity such as customer returns, product discounts, or product recalls. Cost of goods sold is the sum of the raw materials, labor, and overhead attributed to each product. Inventory (and by extension cost of goods sold) must be calculated using the absorption costing method as required by generally accepted accounting principles (GAAP).
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 ratio is expressed as a percentage, though companies may also be interested in calculating the dollar amount of contribution margin to understand the per-dollar amount attributable to fixed costs.
How to Calculate Contribution Margin
Contribution margin is the difference between revenue and variable costs. It can be calculated on an aggregate basis or a per unit basis, and contribution margin is reported on a dollar basis:
Contribution Margin=NSR−VCwhere:NSR=Net sales revenueVC=Variable costs
Net sales is calculated the same for contribution margin as gross margin. However, variable costs are different than cost of goods sold. Often, a company's cost of goods sold will be comprised of variable costs and fixed costs. Variable costs are only expenses incurred in proportion of manufacturing; for example, manufacturing one additional unit will result in a little bit of materials expense, labor expense, and overhead expenses.
It is possible for a product to have a positive contribution margin yet a negative gross margin.
Most often, a company will analyze gross margin on a company-wide basis. This is how gross margin is communicated on a company's set of financial reports, and gross margin may be more difficult to analyze on a per-unit basis.
Alternatively, contribution margin is often more accessible and useful on a per-unit or per-product basis. A company will be more interested in knowing how much profit for each unit can be used to cover fixed costs as this will directly impact what product lines are kept.
Different Expense Considerations
Gross margin considers a broader range of expenses than contribution margin. Gross margin encompasses all of the cost of goods sold regardless of if they were a fixed cost or variable cost.
The primary difference is fixed overhead is included in cost of goods sold, while fixed overhead is not considered in the calculation for contribution margin. As contribution margin will have fewer costs, contribution margin will likely always be higher than gross margin.
Investors, lenders, government agencies, and regulatory bodies are interested in the total profitability of a company. These users are more interested in the total profitability of a company considering all of the costs required to manufacture a good.
On the other hand, internal management may be most interested in the costs that go into manufacturing a good that are controllable. Management may have little to no say regarding fixed costs; therefore, internal members of a company often focus more on the elements they are responsible for (i.e. the variable costs) that fluctuate with production levels.
Different Reporting Requirements
Technically, gross margin is not explicitly required as part of externally presented financial statements. However, external financial statements must presented showing total revenue and the cost of goods sold. Often, externally presented reports will contain gross margin (or at least both categories required to calculate gross margin).
On the other hand, a company is not required to externally disclose its amount of variable costs. In its financial statements, it is not required to bifurcate fixed expenses from variable costs. For this reason, contribution margin is simply not an external reporting requirement.
Different Levels of Transparency
Under either method, a company's ultimate net income will be the same. Because gross margin encompasses all costs necessary to manufacture a good, some may argue it is a more transparent figure. On the other hand, a company may be able to shift costs from variable costs to fixed costs to "manipulate" or hide expenses easier.
For example, consider a soap manufacturer that previously paid $0.50 per bar for packaging. Should the company enter into an agreement to pay $500 for all packaging for all bars manufactured this month. Gross margin would report both types of costs the same (include it in its calculation), while contribution margin would consider these costs differently.
More often used at a company-wide, higher level of analysis
Fixed overhead is included in the calculation
Often used by external parties analyzing a company's overall profitability
Is included in external reporting
Is more difficult to exclude costs; all COGS are considered
More often used at a product-level, lower level of analysis
Fixed overhead is excluded from the calculation
Often used by internal management to determine operational strategies
Is strictly an internal reporting metric
Is easier to exclude costs when shifted between variable and fixed
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.
There's little value in comparing a company's gross margin to its contribution margin. Each metric is used in different ways, and it isn't overly helpful to compare the two.
Other Profit Metrics
Gross margin and contribution margin are just two of the many different types of profit metrics. Other examples of profit metrics include:
- Operating Profit: Operating profit is the amount of money a company earns after all costs of goods sold, operating expenses, depreciation, and amortization have been subtracted from net revenue.
- Pre-Tax Profit: Pre-tax profit is the amount of money a company earns after all costs except for taxes have been considered. This is often calculated as operating profit less interest expense.
- Net Income: Net income is the amount of money a company earns after all expenses have been deducted from net revenue.
- Accounting Profit: Accounting profit is the amount of money a company earns in accordance with GAAP. GAAP rules require that net income be included on a company's income statement.
- Economic Profit: Economic profit is the sum of the accounting profit and opportunity cost. It attempts to recognize the all expenses, even ones that result in benefits foregone.
- Other Comprehensive Income: Other comprehensive income (OCI) is an accounting metric that recognized gains and losses yet to be realized.
What Is a Good Contribution Margin?
A product's contribution margin will largely depend on the product, industry, company structure, and competition. Though the best possible contribution margin is 100% (there are no variable costs), this may mean a company is highly levered and is locked into many fixed contracts. A good contribution margin is positive as this means a company is able to use proceeds from sales to cover fixed costs.
Is Contribution Margin Higher Than Gross Margin?
Yes, contribution margin will be equal to or higher than gross margin because gross margin includes fixed overhead costs. As contribution margin excludes fixed costs, the amount of expenses used to calculate contribution margin will likely always be less than gross margin. The total of net revenue for both is the same.
Do You Want a High or Low Contribution Margin?
In general, a higher contribution margin is better as this means more money is available to pay for fixed expenses. However, some companies may prefer to have a lower contribution margin. Although the company has less residual profit per unit after all variable costs are incurred, these types of companies may have little to no fixed costs and maybe keep all profit at this point.
What Is a Good Gross Margin?
Similar to contribution margin, a good gross margin highly depends on the company, industry, and and product. For example, the state of Massachusetts claims food retailers earn a gross margin around 20%, while specialty retailers earn a gross margin up to 60%.
What Is the Difference Between Gross Profit and Gross Margin?
Gross profit is the dollar difference between net revenue and cost of goods sold. Gross margin is the percent of each sale that is residual and left over after cost of goods sold is considered. The former is often stated as a whole number, while the latter is usually a percentage.
The Bottom Line
As a company becomes strategic about the customers it serves and products it sells, it must analyze its profit in different ways. Two of those ways are gross margin and contribution margin. Gross margin encompasses all costs of a specific product, while contribution margin encompasses only the variable costs of a good. While gross profit is more useful in identifying whether a product is profitable, contribution margin can be used to determine when a company will breakeven or how well it will be able to cover fixed costs.