Definition
Contribution Margin refers to the revenue remaining after subtracting the variable costs that go into producing a product, helpful in determining the profitability for individual items sold. Gross Margin, otherwise known as gross profit margin, is the difference between revenue and cost of goods sold (COGS), divided by revenue, expressed as a percentage, indicating the portion of total sales revenue that the company retains after incurring direct costs associated with producing the goods and services sold. Though both are profitability ratios, the main difference is that gross margin considers only cost of goods sold whereas contribution margin considers all variable costs.
Key Takeaways
- Contribution Margin and Gross Margin are two key metrics in cost accounting that help businesses understand profitability. While both reflect profit on sales, they take into account different types of costs. Contribution margin considers variable costs associated with the production of products, whereas gross margin considers both variable and fixed costs.
- The Contribution Margin Ratio is used to analyse the profitability for individual items that a company makes and sells. Specifically, it is used to review the variable costs included in the production cost of an individual item. On the other hand, Gross Margin is used to assess the total profitability of a company’s product line, considering both direct/variable costs and indirect/fixed costs.
- These two financial metrics provide essential insights for decision-making. They are used to determine the break-even point of a business (how many units it needs to sell to cover its costs) and to make decisions about product pricing and product mix. Despite their differences, both contribute to an effective profit and loss management strategy.
Importance
Understanding the difference between Contribution Margin and Gross Margin is crucial in financial decision making as they provide distinct indications about a company’s profitability and efficiency.
The Contribution Margin refers to the revenue remaining after subtracting the variable costs that go into producing a product; it depicts the profitability for individual items that a company makes and sells, and is particularly useful in determining whether to keep or discontinue a product line.
On the other hand, the Gross Margin represents the total sales revenue less its cost of goods sold (which includes both variable and fixed costs), highlighting the effectiveness of a company in using its resources, labor, and supplies in production processes.
By assessing these margins in conjunction, a company can establish a balanced view of its overall financial health, operational efficiency, and production costs that can guide in strategic planning and forecast.
Explanation
The Contribution Margin is primarily used for internal management reporting. It helps in evaluating how changes in output levels would impact profitability. This margin calculates the profitability for individual items that a company makes and sells. Specifically, the 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, as it deduces the variable costs involved in producing that particular item from its revenue. On the other hand, Gross Margin is used for both internal and external reporting purposes. It looks at a company’s total production cost compared to the company’s total gross revenue. Unlike Contribution Margin, it doesn’t consider the costs for each separate item.
Instead, it regards the company’s cost of making all items as a whole. It measures the total available earnings to cover operating and other costs and enables comparisons across different companies to determine profitability. Both of these metrics offer a view of the company’s profits, but they differ in scope, usage, and calculation.
Examples of Contribution Margin vs Gross Margin
Restaurant Industry: A specific restaurant sells gourmet burgers for $15 each. The direct materials to make each burger (i.e., bun, beef, cheese, veggies) cost $The contribution margin (selling price – variable costs) for each burger would be $
However, the gross margin also considers fixed costs, such as utilities, rent, and salaries for employees. If these fixed costs amount to $2000 a month and the restaurant sells 500 burgers a month, then the gross margin is the sales revenue minus the cost of goods sold: ($15*500)-($5*500+$2000) = $Apparel Manufacturing: A garment manufacturer sells a dress for $
The direct materials (fabric, thread) and direct labor for manufacturing cost $Thus, the contribution margin is $70 per dress. But, the gross margin also accounts for production overhead/fixed costs like rent and monthly machinery maintenance costs. If these are $10,000 per month, and the company makes and sells 200 dresses a month, the gross margin would be: ($100*200)-($30*200+$10000) = $
Tech Startups: For instance, a software company sells a subscription plan for $200 per month. The variable expenses, such as cloud server costs and per-user license fees, amount to $50 per month per user. Hence, the contribution margin per user per month is $However, to calculate gross margin, we need to subtract the fixed costs like salaries, rent, etc. If these fixed costs amount to $20,000 a month and the company has 200 users, the gross margin would be: ($200*200)-($50*200+$20000) = $10,
FAQ Section: Contribution Margin vs Gross Margin
What is Contribution Margin?
Contribution Margin is a cost accounting concept that allows a company to determine the profitability for individual items that they sell. It is calculated by subtracting the total variable costs involved in producing a product from the revenue made from selling that product.
What is Gross Margin?
Gross Margin is a company’s total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. It represents the percent of total sales revenue that the company retains after incurring the direct costs associated with producing the goods and services it sells.
What is the main difference between Contribution Margin and Gross Margin?
The main difference lies in the costs deducted from sales to calculate each margin. Gross margin considers only the cost of goods sold (COGS) in its calculation, while the contribution margin considers all variable costs involved in producing a product, which can also include things like sales commissions and delivery charges.
Why are Contribution Margin and Gross Margin important?
Both margins help to measure a company’s efficiency. Gross margin measures how effectively a company uses its materials and direct labor to produce and sell products profitably. Contribution Margin on the other hand, helps a company to determine the profitability for individual items they sell.
Can a company have a high Gross Margin but a low Contribution Margin?
Yes, this situation can occur when a company has high variable costs. Even if a company has a high gross margin, it may result to a low contribution margin if their variable costs are high, such as marketing costs or commission-based sales structure.
Related Entrepreneurship Terms
- Variable Costs: These refer to costs that change with the level of output in production. They are central to understanding contribution margin since it accounts for variable costs.
- Fixed Costs: These are static costs incurred regardless of output level. Although not directly accounted for in the calculation of contribution margin, they are crucial in overall profitability contexts.
- Revenue: This is the total amount of income generated by the sale of goods or services. Both gross and contribution margins subtract some form of cost from revenue to determine profitability.
- Cost of Goods Sold (COGS): This term is a specific type of cost that includes the direct costs attributable to the production of goods sold by a company. It is the key cost subtracted from revenue to derive the gross margin.
- Operating Profit: This is a profitability measure showing earnings from operating activities. It’s calculated after deducting all operating expenses, including COGS and other expenses such as rent and salaries, but before interest and taxes. Both contribution margin and gross margin are steps along the way to calculating operating profit.
Sources for More Information
- Investopedia – A detailed knowledge resource to understand different aspects of financial and investment terminology.
- Accounting Tools – A comprehensive source of practical financial, accounting, and business information.
- Corporate Finance Institute – Provides professional financial analyst training and comprehensive education in corporate finance and financial modeling.
- The Balance Small Business – Offers useful guides and tips about different aspects of small businesses including financial concepts.
