Gross margin includes all expenses directly related to sales, while contribution margin only includes variable expenses related to sales. Learn what the difference is and why it’s important.
What’s the Difference Between Contribution Margin and Gross Margin?
Sales - Variable expenses Variable expenses are all expenses directly related to the unit being sold that change with the number of sales. Sales commissions and shipping are examples of variable expenses. The contribution margin ratio is a helpful metric based on contribution margin. It expresses the contribution margin as a percentage of sales:Contribution margin / Sales The gross margin formula is: Sales - Cost of goods sold (COGS) COGS include all expenses directly related to manufacturing a product or delivering a service. Materials, labor, shipping, inventory, and rent are examples of COGS.
What It Does
Contribution margin reveals how individual components of the business are performing, such as products or individual departments. Contribution margin only includes variable expenses related to producing and selling specific products. It doesn’t include any fixed expenses, and often appears in its own income statement. Gross margin shows business owners how well they’re allocating resources to the products and services that they offer. Gross profit margin doesn’t include indirect expenses such as accounting and legal fees, corporate expenses, and office expenses.
What It’s Used For
Companies use contribution margin to evaluate the profitability of individual products and managers. It’s a tool to evaluate performance because fixed expenses that managers don’t control aren’t included. Business owners can use the contribution margin to calculate the level of sales needed to break even at both the business level and on product-related sales and marketing initiatives because it represents the total dollars available to offset expenses. Businesses can use gross margin to look at the overall health of the business, and it appears on the income statement. You can look at the changes in gross profit margins on a quarterly and annual basis, and relate that to marketing, sales, and cost-reduction efforts. Looking at the gross margin over time is also an indicator of the business’s growth and efficiency. Business owners can use gross profit margins to benchmark themselves against competitors. Gross profit margin ratios by industry are readily available. Gross margin is also useful to analyze customer sales and profitability. Identifying the most profitable customers can help business owners determine what their ideal customer profile looks like, and plan accordingly.
Advantages and Disadvantages of Contribution Margin and Gross Margin
Contribution Margin Pros and Cons
The contribution margin of individual products is easier to calculate because it only includes expenses that vary directly with sales, such as materials and commissions. However, using contribution margin as the basis for forecasting profits can be misleading. Fixed expenses don’t always remain constant as sales grow, which changes the contribution margin break-even for sales.
Gross Margin Pros and Cons
The big advantage of gross margin for analyzing the business is that it’s a standard metric. It’s easy to compare how your business is performing relative to the industry you’re in, and can help you avoid pricing problems. A disadvantage of gross margin calculations is that they do not take into account other important costs, such as administration and personnel expenses, that could affect profitability. Also, depending on the type of business you’re in, it may be difficult to calculate COGS for individual products.
