Wajiha Danish | October 20 2023
Occasionally, investors and company leaders might mix up gross profit or margin with contribution margin. Big mistake!
It’s absolutely important to understand that an organization’s gross profit is not the same as its contribution margin.
Why, you ask?
Because the purpose of each is different. So is their calculation, of course.
Gross profit is used to assess an organization’s financial health and performance. It’s determined by dividing the gross profit by its net sales.
The contribution margin, on the other hand, represents the difference between the organization’s total sales and its total variable expenses. This figure helps in evaluating how efficiently the organization manages its production processes and controls its variable costs.
Let’s take a deeper look into each.
Gross margin is also a crucial financial measure, but this one is closely tied to net revenue or gross profit margin. It specifically considers the amount a company earns, and the direct costs associated with making its products or services. It doesn’t take into account operational expenses like the amount spent on marketing, sales activities, and other costs such as taxes or interest on loans.
Essentially, when we talk about gross margin, we’re focusing on the factory-related expenses like the cost of raw materials and labor, but we’re leaving out the administrative costs related to running the company’s headquarters.
The direct manufacturing costs are also known as the cost of goods sold (COGS). This figure represents the money spent on producing the items or services a company sells. The gross margin essentially tells us how efficiently a company generates income from its direct expenses, like the cost of materials and labor. To calculate the gross margin, we subtract the cost of goods sold from the revenue and then divide the result by the revenue. The final number can be multiplied by 100 to express it as a percentage.
In simpler terms, the gross profit margin, often called ‘gross margin,’ is a broad measure of the overall profit a company makes on its sales after subtracting only the costs directly associated with production. It doesn’t provide a complete picture of a company’s overall profitability, but it does illustrate the relationship between production costs and total sales revenue.
You can find the gross margin in a company’s income statement as the difference between the income from sales and the cost of goods sold.
Formula:
Gross profit margin = Total sales revenue – Total direct cost of goods sold.
The contribution margin is like a special profit number for each product a company sells. It’s the money you make from selling something after you subtract the costs that go up and down with how much you sell. We don’t count the costs that stay the same in the case of contribution margin – examples of fixed costs include workers’ salaries or rent.
The contribution margin helps figure out when a company starts making money. The higher the contribution margin, the quicker the company makes a profit, because more of the money from each sale can cover the fixed costs.
Fixed costs are costs that don’t change, such as rent or salaries. But variable costs change with sales – sales commissions, for instance. So, when sales go up, variable costs go up too.
In simple terms, think of gross profit as the overall profit for the whole company, while contribution margin is like the profit for one thing the company sells.
To calculate the contribution margin for something, you first figure out how much money you get from selling it, then subtract the variable costs that come with making it, and finally, you divide the figure achieved by the income you earned from selling it.
Formula:
Contribution Margin = (Sales figure for an item – Variable Costs incurred to make it) ÷ Sales figure for that item.
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Contribution margin vs Gross margin |
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| Contribution Margin | Gross Margin | |
| Contribution margin is the money a business earns from sales after subtracting only the variable costs, such as labor, overhead, and materials.
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Meaning
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Gross margin is the money a business earns from sales after deducting the cost of the goods it sold.
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| Contribution margin = (Sales – Variable Costs) / Sales
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Formula | Gross margin = (Revenue – Cost of Goods Sold) / Revenue
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| Used to analyze the profit generated by each product individually. | Profitability Metrics | Helps assess the overall profitability of the business. |
| Only variable costs are considered when calculating it.
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Factoring Fixed Cost and Variable Cost | It takes into account both fixed and variable expenses related to product production. |
| Useful for long-term analysis and various scenarios. | Application | Used for historical assessments, calculations, or projections with specific sales figures. |
| Aids in setting prices. A low or negative contribution margin suggests that a product may not be profitable.
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Significance | Indicates whether sales cover the costs of production. |
Both gross margins and contribution margins are essential measures of how well a business is doing. These measures help us make SMART decisions to increase profits by considering different factors, like choosing the best products to invest in, evaluating which marketing and advertising strategies work best, and finding ways to improve cost of production. The gross margin tells us how well the company is doing overall, while the contribution margin tells us how much profit each product contributes.
Also Read: What Is Marginal Cost, Its Formula, And How To Calculate It?
Wajiha is a Brampton-based CPA, CGA, and Controller with 17+ years of experience in the financial services industry. She holds a Bachelor of Science Degree in Applied Accounting from Oxford Brookes University and is a Chartered Certified Accountant. Wajiha spearheads Monily as its Director and is a leader who excels in helping teams achieve excellence. She talks about business financial health, innovative accounting, and all things finances.
