Gross Margin vs. Contribution Margin: What's the Difference?

Gross Margin vs. Contribution Margin: An Overview

Gross margin measures revenue after subtracting the costs associated with production. It represents revenue minus the costs of goods sold (COGS). The contribution margin measures the profitability of individual products based on their variable costs and can be used to determine the breakeven point.

Gross margin is commonly used as an aggregate measurement of a company's overall profitability. The contribution margin is used by internal management to gauge the variable costs of producing each product.

Gross Margin

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, marketing costs, taxes, or loan interest. The metric uses direct labor and direct materials costs, not administrative costs for operating the corporate office. 

Direct production costs are the cost of goods sold (COGS) and include raw materials, labor, and overhead attributed to each product. The 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, dividing the result by revenue, and multiplying by 100 to find a percentage.

$\begin{aligned}&\textbf{Gross Profit Margin}=\frac{\textbf{Net Sales}-\textbf{COGS}}{\textbf{Net Sales}}\\&\textbf{where:}\\&\textbf{COGS}=\text{Cost of goods sold}\end{aligned}$​Gross Profit Margin=Net SalesNet Sales−COGS​where:COGS=Cost of goods sold​

Contribution Margin

The contribution margin subtracts the variable costs for producing a single product from revenue. The contribution margin measures the profitability of individual items that a company makes and sells. This margin reviews the variable costs included in the production cost and a per-item profit metric, whereas gross margin is a company's total profit metric.

The contribution margin ratio is expressed as a percentage, but companies may calculate the dollar amount of the contribution margin to understand the per-dollar amount attributable to fixed costs.

$\begin{aligned}&\textbf{Contribution Margin}=\textbf{NSR}-\textbf{VC}\\&\textbf{where:}\\&\textbf{NSR}=\text{Net sales revenue}\\&\textbf{VC}=\text{Variable costs}\end{aligned}$​Contribution Margin=NSR−VCwhere:NSR=Net sales revenueVC=Variable costs​

Net sales are the same for contribution margin as gross margin. However, variable costs differ from COGS. Variable costs are only expenses that result in producing each additional unit.

Key Differences

• Implementation: A firm commonly analyzes gross margin company-wide through financial reports. Alternatively, contribution margin is useful on a per-unit or per-product basis. It shows how much the profit of each unit can be used to cover fixed costs and directly impacts product lines.
• Expense Considerations: Gross margin encompasses all costs of goods sold, whether fixed or variable. Fixed overhead is only included in the gross margin, not the contribution margin. With fewer costs, the contribution margin will likely always be higher than the gross margin.
• Users: Investors, lenders, government agencies, and regulatory bodies are interested in the total profitability of a company. Conversely, internal management may be most interested in the costs they can control to manufacture individual goods, that is, the variable costs that fluctuate with production levels.
• Reporting Requirements: Gross margin is not explicitly required in externally presented financial statements. However, financial statements must show total revenue and the cost of goods sold, which means reports will contain gross margin. Companies are not required to disclose variable costs. In its financial statements, it is not mandatory to bifurcate fixed expenses from variable costs, so the contribution margin is not an external reporting requirement.
• Transparency: A company's ultimate net income will be the same with both margins. 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 shift costs from variable to fixed costs to "manipulate" or hide expenses.

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. 

Company XYZ receives $10,000 in revenue for each widget it produces, while variable costs for the widget are $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 is 40%, or ($10,000 - $6,000) / $10,000.

Contribution margin is not an all-encompassing measure of a company's profitability. However, 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 calculate how to improve its profitability, either by reducing variable production costs or increasing the item's price.

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 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 taxes have been considered. This is often calculated as operating profit less interest expense.
• Net Income: Net income is the amount a company earns after all expenses have been deducted from net revenue.
• Accounting Profit: Accounting profit is the amount of money a company earns under 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 all expenses.
• Other Comprehensive Income: Other comprehensive income (OCI) is an accounting metric recognizing gains and losses to be realized.

The Bottom Line

Two ways a company assesses profits 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 break even or how well it covers fixed costs.