Gross Margin vs Contribution Margin Formula
How to calculate gross margin
Simply deduct the cost of goods sold (COGS) from the total net sales to get the gross margin. Here are the steps you can take:
1. Determine total revenue
The first thing you must do is determine your total sales revenue because gross margin is calculated by deducting COGS from total revenue. Examining your income statement should help you locate this number.
2. Cost of goods sold
Your income statement should contain a line item for COGS. The process of calculating COGS begins with your annual inventory at the beginning of the year and ends with another inventory at the end of the year.
3. Calculate gross margin
The following step is to deduct the cost of sales from the overall revenue that you calculated in step one. Then divide that number by the total revenue. As a formula, it looks like this:
Gross margin is calculated as (total revenue – cost of goods sold) / total revenue.
4. Calculate as a percentage
This last step is actually optional. However, all you have to do to convert the gross margin to a percentage is multiply it by 100. The entire gross margin formula looks like this:
Gross profit margin is calculated as [(Total Revenue – Cost of Goods Sold) / Total Revenue] x 100.
What is the difference between gross margin and contribution margin?
The operating costs, such as salaries, advertising, and taxes, are not included in the gross margin. You can gauge how effectively a company is generating revenue by producing goods and services by looking at the gross margin.
Although these two profit measurements are very similar, the main distinction is that contribution margin is a per item metric while gross profit margin is a total profit metric. Additionally, the contribution margin is typically expressed as a percentage, whereas the gross margin is typically expressed as an absolute value, though it can also be expressed as a percentage by multiplying it by 100.
How to calculate contribution margin
The contribution margin is calculated by deducting variable costs from sales revenue. Here are the basic steps you should take:
1. Determine total sales revenue
Determine your total sales revenue using your income statement. Before any costs are deducted, this figure represents the total amount of money you made from sales.
2. Determine variable costs
To do this, you must determine every expense involved in producing a single product unit. Labor costs, variable overhead costs, and material costs are examples of common types of variable costs. All of these costs vary depending on how many products you’re producing. Simply multiply the variable costs for producing one unit by the overall number of units produced to get the total variable costs. You could also total up all of your variable costs in your ledger. Some you may want to consider are:
3. Calculate contribution margin
By deducting your variable costs from your total sales revenue after you have determined all of your variable costs, you can determine your contribution margin. You would divide the contribution margin by sales revenue to obtain the contribution margin as a ratio. The formula looks like this:
Contribution margin ratio = (Sales revenue – variable costs) / Sales revenue
Gross margin example
Heres an example of how you could calculate gross margin:
Consider owning a company that generates $300,000 in annual sales. The COGS consists of $100,000 in labor costs and $60,000 in manufacturing supplies. That makes the COGS $160,000. As a formula, it would look like this:
($300,000 – $160,000) / $300,000 = 0.47
You only need to multiply that by 100 to convert it to a percentage, giving you a gross margin of 47%.
Contribution margin example
Let’s take an example where a company’s total sales revenue was $500,000 and the variable costs were determined to be $300,000 after accounting for labor, materials, packaging, and shipping. The contribution margin in this situation is 0. 4 or 40%. The formula to reach that number is:
($500,000 – $300,000) / $500,000 = 0.4
When you multiply that number by 100 you get 40%.
Frequently asked questions about gross and contribution margin
The following are some of the most typical queries regarding gross and contribution margin:
Is contribution margin always higher than gross margin?
When determining the contribution margin, the fixed overhead costs are never taken into account. Therefore, a company’s contribution margin will always be higher than its gross margin.
What affects gross margin?
Sales revenue and merchandise costs are the two most readily apparent factors that affect a company’s gross margins. You can get a general understanding of these two factors by looking at your income statement.
Is a high contribution margin good?
A contribution margin should be as close to 100% as possible. The higher the ratio, the more revenue the business is bringing in to cover its overhead costs or fixed costs.
What can a business do to improve its contribution margin?
By improving operational efficiencies, a business can increase its contribution margin. Consider ways to lower the price of product acquisitions and material purchases. You could also look for machinery that is more productive so you can produce the same number of goods in a shorter amount of time. Increasing prices is another way to increase your contribution margin.
Is contribution margin higher than gross margin?
Comparing Contribution Margin and Gross Margin The main distinction between Contribution Margin and Gross Margin is that Contribution Margin excludes fixed overhead costs. Accordingly, the contribution margin always exceeds the gross margin.
How do you calculate gross margin and contribution margin?
Contribution margin is a measure of a company’s profitability for a particular product or line of products. The contribution margin is calculated by deducting all of the variable costs associated with producing a specific product from its selling price.
What is the difference between GP and GM?
While they measure similar metrics, gross margin and gross profit are different in that the former measures the percentage (or dollar amount) of profit from the sale of the product, while the latter measures the comparison of a product’s cost to its sale price.
What’s the difference between gross margin and profit margin?
The production costs, such as parts and packaging, are subtracted from the revenue to determine the gross profit margin. The ultimate indicator of a company’s profitability is its net profit margin, which is the bottom line of the business expressed in percentage terms.