Gross margin and contribution margin are quite similar to one another and are important indicators of a company’s profitability. They both offer information that is important to make decisions regarding production levels. Contribution allows a company to calculate the breakeven point (which is the amount of goods that need to be sold for the company to breakeven). Gross profit helps a firm compare various products and services and to identify which products the company produces are the most profitable. The article offers a comprehensive explanation on each term and shows the similarities and differences between contribution margin and gross margin.
Gross Margin
The gross margin (also called the gross profit margin) is the percentage of total sales that is retained by a company once all costs associated with producing and selling goods and services have been accounted for. Gross margin is calculated as total sales revenue for the year – cost of goods sold, divided by total revenue for the year. The number calculated is the percentage that the company retains on each $1 of sales, to pay for its other expenses. Investors generally tend to invest their money in companies that carry a higher gross margin, meaning that a company with a higher gross margin is making more money. Gross profit and gross margin are important indicators of a company’s profitability. Gross margin also helps companies decide the price at which they should sell goods and services. Gross margin also provides an indicator as to whether the company’s cost of goods sold are too high and are in need of control.
Contribution Margin
In order to explain contribution margin, an understanding of the company’s costs are essential. A company has two types of costs; fixed costs and variable costs. Fixed costs do not change with the company’s output (except after a certain level) but variable costs will increase as output increases. The contribution margin is calculated by reducing the variable costs of making a product from the sales revenue to reveal what is left over to pay for fixed expenses. Contribution margins are helpful when calculating a company’s breakeven point. Contribution can also be calculated on a per unit basis, and which will show the funds that a company receives with each sale.
What is the difference between Contribution Margin and Gross Margin?
Gross margin and contribution margin are both calculated from figures that appear on a company’s income statement. Gross margin and contribution margin are both helpful to businesses when making decisions regarding production levels. Both these figures provide an indication on a company’s profitability; however, there are a number of differences between the two. The main difference is that, when calculating gross margin, the cost of goods sold that is reduced from total revenue can include fixed costs and variable costs, whereas the contribution margin is calculated by reducing only variable costs from total revenue.
Summary:
Contribution Margin vs Gross Margin
• Gross margin and contribution margin are quite similar to another and are important indicators of a company’s profitability.
• The gross margin (also called the gross profit margin) is the percentage of total sales that is retained by the company once all costs associated with producing and selling goods and services have been accounted for.
• The contribution margin is calculated by reducing the variable costs of making a product from the sales revenue to reveal what is left over to pay for fixed expenses.
• When calculating gross margin, the cost of goods sold that is reduced from total revenue can include fixed costs and variable costs, whereas the contribution margin is calculated by reducing only variable costs from total revenue.