One of the most important aspects of running a business is understanding the numbers that describe the financial health of your company. Two of those important numbers, which on the surface can seem similar, are the contribution margin and the gross margin. Understanding the differences between the two can affect your business strategies related to pricing, product selection, and overall business strategy.
In this guide, we will begin by explaining what is a contribution margin and how understanding this concept is beneficial to your business. Then, we will look at gross margin for you to be able to utilize both of these business metrics. When you complete this guide, you will have gained a solid understanding of both of these business terms and how they can help improve the financial health of your business.
What Is a Contribution Margin?
The contribution margin is defined as the amount of money that remains after you have paid the variable costs that go into producing a product. That leftover amount is what you use to pay your fixed costs, which include rent, salaries, and other similar expenses. After paying the fixed costs, whatever money is left is your profit.
The two metrics that will tell you a lot about the health of your business and that are often confused are contribution margin and gross margin. They seem similar, but different things tell you about your business.
Calculating Contribution Margin
Calculating contribution margin is not that difficult. All you have to do is write down your total sales and subtract your total variable costs.
Contribution Margin = Sales Revenue – Variable Costs
Let’s consider an example. Suppose you have a small business that sells and manufactures leather wallets.
You sell a single wallet for $7.14. This is considered your sales revenue per unit.
For one wallet, the leather, thread, and packaging cost $2.86. This is your variable cost.
Let’s compute the contribution margin for a single wallet from the variable costs and sales.
$7.14 (Sales) – $2.86 (Variable Costs) = $4.28
This means that your contribution margin for every wallet is $4.28. This is not yet your profit, as you still have to consider your fixed costs.
What are Variable and Fixed Costs?
You need to know some terminology to understand contribution margin, particularly variable costs and fixed costs.
Variable Costs
These costs change depending on how much you produce. For example, if you produce more wallets, you need to buy more leather to make those wallets, and your leather costs increase. Examples are
- Raw materials (leather, fabric, plastic, etc.)
- Direct labor costs (wages for workers who produce the product)
- Sales commissions
- Shipping/delivery costs
Fixed Costs
These costs do not change regardless of the number of products produced or sold. These are constant payments you must make every month. Examples are
- Rent for your workshop/office
- Salaries of your administrative employees
- Insurance
- Monthly taxes and utilities (including internet)
Contribution margin focuses on what your sales have contributed towards covering your variable costs.
Why is contribution margin so important?
1. Profitability of Products
A contribution margin answers the questions of the profitability of products. A product creating a large contribution margin after variable costs have been covered brings in more money, helping the business cover the fixed costs.
You may decide to put more focus on promoting this product. If the contribution margin resulting from a product is too low, it can help the company focus on ways to decrease the variable costs of it or to increase the price of the product.
2. Aiding in Pricing Decisions
Defining contribution margin helps a business to land the right price of a product. A business must ensure the price of a product is set to cover variable costs, and the fixed costs should not be negatively impacted. Contribution margin indicates to a business the minimum price a product can be set to in order to cover the costs incurred on every sale.
3. Break-Even Analysis
This is a very important contribution margin introduced in a break-even analysis. When the total costs of a business equal its total sales, no profit or loss is being made. This is referred to as the break-even point, and it is very important to utilize the contribution margin to determine this point.
To calculate your break-even point in terms of units, apply the following formula:
Break-Even Point (Units) = Total Fixed Costs / Contribution Margin Per Unit.
Let’s use the wallet case example again, shall we?
We are assuming your total fixed costs (rent, salaries, etc.) are $428.57 per month, right?
Your contribution margin per wallet is $4.28, yes?
Break-Even Point = $428.57 ÷ $4.28 = 100 units
What Exactly Is Gross Margin?
Let’s now consider yet another measure of profitability, which is gross margin, also known as gross profit margin. This is basically how much is left after deducting the cost of goods sold (COGS) from your sales revenue.
Typically, the figure is expressed in percentages.
Explaining Gross Margin Calculation
Below is the gross margin formula.
Gross Margin (%) = [ (Sales Revenue – Cost of Goods Sold) / Sales Revenue ] x 100
Key Differences Between Contribution Margin And Gross Margin
The main difference between contribution margin and gross margin is the costs that are deducted from sales.
- Contribution margin is derived by deducting ONLY the variable costs.
- Gross margin deducts the cost of goods sold (COGS), which can have both variable and fixed production costs.
This also explains the different applications of the two metrics.
Contribution margin is ideally for internal use. It is an invaluable analytical tool for managers on the micro level and, on the macro level, for the entire company on the operational continuum, whether at the point of product, price, or production level. It answers operational questions, such as “Should we stop selling this product?” or “How many units do we need to sell to be profitable?”
Gross margin is normally regarded as a financial metric, which is why it is also used externally. Investors and banks are most concerned with this metric, as it shows the level of streamlining of the production of the company’s goods.
To summarize the differences, please see the simple table below:
| Feature | Contribution Margin | Gross Margin |
| Costs Subtracted | Variable Costs Only | Cost of Goods Sold (COGS) |
| Purpose | Internal decision making | Overall financial health |
| Format | Can be per unit, total amount, or percentage | Usually a percentage |
| Focus | Profitability of individual products | Overall production efficiency |
