If you've ever wondered what the difference was between Gross Margin and Contribution Margin, then this article is for you! We'll take a look at the definitions and differences of these two economic terms, as well as some key considerations for each.
What is Gross Margin?
Gross margin is the difference between revenue and the cost of goods sold. It represents how much profit a company generates on its product before accounting for other factors such as overhead expenses or taxes. It can also be calculated by subtracting the cost of goods sold from total revenues.
What is Contribution Margin?
The contribution margin is the difference between total operating expenses and net sales. In a healthy company, it can be used to represent operating profit. For example, if a company generates $1000 in gross margin but it has operating expenses of $800 and net sales of $200, then the contribution margin represents $200 of operating profit.
Differences
The distinction between these two terms can be confusing, especially considering their similarities. Gross margin and contribution margin are both used by accountants in financial statements to report on a company's profitability at a specific point in time. However, there are several key differences that help explain their variations.
1. Gross margin
Gross margin, also known as gross profit or operating margin, is the difference between revenue and operating expenses. It can be calculated by subtracting either the total cost of goods sold (TCS) or manufacturing expenses (Mf) from total revenues.
Why does this matter?
Gross margin is used in financial statements to represent a company's profit based on sales. Gross margin can also be used to forecast future performance by indicating the profitability of a company's products based on their respective price points. Gross margins above a certain level indicate that a company has the ability to generate higher profits within its current industry because it controls costs that are not normally associated with its product.
How to calculate:
Example: Company A sells products that cost $10 each with an average selling price of $15. Their total sales are calculated as follows:
Revenue = (20 * 15) = 375 = $7500
Expenses = (50 + 10) * 12 = 1000
Total expenses remaining of 2500 Total revenues remaining of 75000 = 500
Gross margin is calculated as follows since total revenues are less than total expenses as well as the formula for calculating gross margin indicates that the difference will be income.
Revenue - Total expenses = $7500 - $1000 = $6500 = 30%
2. Contribution margin
The contribution margin is the difference between total operating expenses and net sales. In a healthy company, it can be used to represent operating profit. For example, if a company generates $1000 in gross margin but it has operating expenses of $800 and net sales of $200, then the contribution margin represents $200 of operating profit.
Why does this matter?
The contribution margin is the amount of money that a company makes from its products before accounting for other factors such as overhead expenses or taxes. This number can be used to forecast future performance by determining what sales volume is necessary for a company to break even.
How to calculate:
Example: Company X generated revenues of $800,000, TCS of $250,000, and operating expenses of $350,000.
Total operating expenses were $350,000 relevant total revenues were $800,000.
Net sales were $800,000 - $350,000 = $450,000
Contribution margin was ($350,000 - $800,000) / 80000 = 30%
Why should you care about contribution margin?
Total revenue (the amount of money your company gets for selling all its products) minus the cost of goods sold (all your labor and other expenses to get those products sold) equals contribution margin. This means that contribution margin is the amount of total revenue left over after a company pays its cost of goods sold. The difference between gross profit and contribution margin is that gross profit tells you what percentage you can make from your sales, while contribution margin tells you how much money you make in total.
Key considerations
1. Which one is best to use?
Overall contribution margin is the most useful of the two because it accounts for overhead expenses in addition to direct costs like materials and labor. Gross margin can only be used to report on a company's profitability in an isolated department or at a specific point in time during the year.
Other key differences
Contribution margin is often used as a benchmark for measuring performance in the C-suite. It is important to remember that contribution margin is not profit, but it represents the first step toward determining what a company must sell in order to break even. Gross margin will vary across industries, and is usually based on the cost of materials for products or services. However, the cornerstone of any business' success is still the ability to control costs, manage expenses and improve profitability over time.
When Should You Use Gross Margin and When Should You Use Contribution Margin?
Gross margin is the percentage of net income from a company's sales. Contribution margin is the rate at which your company can earn money from each unit of product it sells. When you look at gross margin and contribution margin, it's very important that you're using them correctly. Why? Because one metric may not be obvious to someone looking in from the outside.
Gross margin calculation will give you the short-term picture of your company's profitability. But, it's important to use the contribution margin calculation to help us understand how your business works long-term. If you keep doing this (using gross margins and contributing margins) over time, then you'll have a very good understanding of your company's performance and how it should grow in the future.
Does Gross or Contribution Margin Affect Your Business?
The answer to this question is yes and no. Make sure you understand why. Gross margin is a snapshot of your business at one particular moment of time. And it's useful for comparing one year to another because we use the same formula for calculating it every year. For example, in a company's second year of business, the gross margin will be calculated using the same formula as in its first year of business (90% gross margin becomes 90% gross margin again). The contribution margin, on the other hand, is calculated differently every year, because it's a function of your gross profit.
