Just about every company owner has fielded the well-meaning question “How’s business?” from a friend or acquaintance. It’s a simple query, but small business owners know just how complex the answer can be.
Though no single figure can sum up the status of your company completely, there are several metrics that can help you assess its health and identify ways to maximize profit. Among those are contribution margin and gross margin, two ratios that measure profitability in different but important ways.
What is the contribution margin?
Contribution margin measures how much money your business retains after paying variable expenses of making your products. Although it can be used as an overall measure of your business’s profitability, it may be most helpful on a line-item basis to assess the profitability of each product or service you sell.
Because contribution margin assesses how much you retain of a given product’s sales after stripping out variable expenses, such as sales commissions and marketing campaigns, it becomes clear when you have to make tough decisions about which products to invest in more and which to discontinue. If the sales of a product aren’t enough to offset the expenses of making that product, that can be a major problem.
The formula to calculate contribution margin is:
(net sales of the product - variable costs to make that product) / net sales of the product x 100 = contribution margin
Here is how the formula would look using imaginary sales and cost figures: ($20 net sales - $10 variable costs) / $20 net sales x 100 = 50% contribution margin
The higher the contribution margin ratio, the more money you have to cover the business’s expenses—including fixed costs such as rent and materials. So ideally the percentage would be as close to 100% as possible, but it’s probably much lower than that in most cases. Appropriate ratios vary by industry, but many businesses operate at contribution margins of less than 50%.
What is the gross margin?
Gross margin, or gross profit margin, is how much money you have left after accounting for all direct costs of producing your goods and services—such as raw materials and labor directly involved in making or distributing those items. It’s a key measure of your core business, and it gives you an overall sense of how profitable the company is as well as its potential for improvement.
Put another way, gross profit margin can help your business monitor profitability over time, because it takes into account the variable and fixed costs directly involved in production: You’re comparing the sales you generated with the cost of labor, materials, and any other direct costs in that specific time period. So if your business isn’t retaining enough profit, gross margin can highlight necessary changes to production costs or pricing models.
Typically, gross margin is expressed as a percentage. A gross margin of, say, 37%, means your company retains 37¢ for every $1 of revenue.
The gross margin formula is:
[(total revenue - cost of goods sold) / total revenue] x 100 = gross margin
As this shows, gross margin is a ratio that includes two accounting metrics. The first is total revenue, or net sales, which is your gross revenue minus any returns or discounts of your products. The second is cost of goods sold (COGS), which is direct production costs, including materials and labor. Both metrics are found on a business’s income statement, which details a company’s net income over a certain reporting period—usually a quarter or a year.
Here’s a theoretical example: A pottery maker sells $6,000 worth of goods in the first quarter, and it costs $2,000 to produce those items.
The formula would look like this:[($6,000 total revenue - $2,000 COGS) / $6,000 total revenue] = 0.66 x 100This indicates that the gross margin is 66%.
Contribution margin vs. gross margin: Key similarities and differences
Contribution margin and gross margin are ratios to provide insight into business profitability, but they consider different types of expense categories and are typically used to inform different types of business decisions.
- How they’re similar: Each ratio is a measure of profitability. Both contribution margin and gross margin consider expenses in relation to sales.
- How they’re different: Contribution margin measures variable costs of producing a product or service, such as sales commissions, and it tells a business owner how much money is left to put toward operating expenses. It focuses on a specific line of business, and it can also help a business owner decide which product lines to invest in and which to cut. Gross margin accounts for any costs directly involved in producing and distributing what a business sells, providing an overall sense of potential profitability given current pricing conditions. It may also highlight the need for changes, like pricing of goods.
Contribution margin and gross margin FAQ
Is the contribution margin always higher than the gross margin?
Yes. Contribution margin takes into account only the variable costs of making a product or service, while gross margin considers all direct costs of production.
Which is better: a lower or higher contribution margin?
Ideally, a contribution margin ratio should be as close to 100% as possible. The higher that number, the more money you have to cover the business’s expenses. However, many businesses operate at contribution margins of less than 50%.
Does contribution margin or gross profit margin tell you more about the health of your business?
Each ratio can be useful to businesses in different ways, but gross profit percentages consider all direct costs of production, including both variable and fixed expenses. Contribution margin, by contrast, accounts for only variable expenses such as sales commissions and marketing.