Gross Margin vs contribution margin (with free simple calculators)
Entrepreneurs and business owners may be some of the hardest-working people you’ll ever meet, but sadly, no amount of hard work can keep a business healthy if the economics are wrong. We’re not talking about the big-picture macroeconomic environment, but the unit-by-unit and line-by-line economics of each product or service you sell.
You need to keep a close eye on your financial metrics to ensure each product line pulls its weight and every sale adds to your success, but which metrics should you use?
Contribution margin vs gross margin
Margin is the fraction of revenue left after certain expenses, but there are different ways of measuring it. Gross margin and contribution margin are both powerful options, each helping you understand your business in a different way. Gross margin shows you the percentage margin left over in your business as a whole after direct costs have been removed. Contribution margin shows you the dollar amount each individual unit contributes to your fixed costs and profits after accounting for variable costs for that unit.
Here’s a quick side-by-side comparison, and then we’ll take a closer look at what these metrics mean, how to use them, and how both are calculated (or jump down to our Gross margin calculator or Contribution margin calculator and crunch some numbers).
What is gross margin?
Gross margin is a financial metric that shows how much money a company has left over after it pays for the direct costs of producing its goods or services. In other words, it's the difference between a company's revenue and the cost of the materials, labor, and other expenses that are directly tied to making its products or delivering its services.
For example, let's say a bakery sells $1,000 worth of cakes in a month. The bakery's direct costs of making those cakes, including ingredients and labor, total $500. The gross margin for the bakery would be $500 (more commonly expressed as a 50% margin), which is the revenue of $1,000 minus the direct costs of $500. This means that the bakery has $500 left over to pay for its overhead expenses, like rent, utilities, and marketing.
Gross margin is an important metric for businesses because it helps them understand how efficiently they produce and sell their products or services. By tracking gross margin over time, companies can make strategic decisions to optimize their operations and increase profitability.
The gross margin calculation
The basic gross margin formula is:
Revenue - Cost of goods sold (also called COGS) = Gross margin
You can see that the formula itself is pretty simple, so let’s dig into the different elements to make sure you start with the right numbers; then, we’ll take a look at how you can use gross margin to improve the profitability and sustainability of your business.
Revenue is a pretty straightforward metric, but there are a couple of options when it comes to the gross margin formula. Gross margin can be calculated using either gross revenue or net sales. Gross revenue is the total revenue brought in from sales activity, while net sales is basically gross revenue minus (or net of) returns, discounts, and allowances.
Using net sales to calculate gross margin will paint a more accurate picture, as your typical discounts, returns, and allowances should be kept in mind when thinking about your margins and profitability. For D2C and retailers who have high returns, or SaaS companies offering annual discounts, these numbers can be the difference between profits and losses. You need to be aware so you can price accordingly.
That said, if your company has very little in the way of discounting or returns, or you’re running a quick calculation and don’t have all that information in front of you, gross revenue could be a reasonable stand-in.
Cost of goods sold (COGS)
Cost of goods sold is exactly what it sounds like. It represents the total cost of producing and delivering goods to customers, including the direct cost of materials, labor, and manufacturing overheads. COGS is typically measured over a specific period, such as a month, quarter, or year, which will match the revenue period you use.
To calculate COGS, you need to factor in all the direct costs incurred during the production process, including raw materials, direct labor, and manufacturing overheads like rent and utilities. It's important to note that only costs that are directly attributable to the production process should be included in COGS. Other expenses, such as marketing and administrative costs, are not included in COGS as they are not directly related to the production process.
While these numbers make sense for companies that sell a product, what about SaaS and service businesses? When you sell a service, you need to factor in the direct labor costs involved in delivering that service, including wages and salaries of the employees who perform the service, as well as any sales commissions paid to reps who bring in new customers.
Software licenses and hosting costs are another direct cost of delivering a SaaS service. By including these costs in their COGS calculations, SaaS and service businesses can get a more accurate picture of the true cost of delivering their services and make more informed decisions about pricing and profitability.
Gross margin vs. gross margin ratio
Just a quick note on two terms you may hear used interchangeably. Gross margin, as we calculated above, is the amount left over after COGS are subtracted from revenue. The gross margin ratio is the percentage of each dollar retained as gross profit, which is calculated by dividing the gross margin by revenue. Using the example above, our bakery had $1000 in revenue and $500 in COGS, leaving a $500 gross margin. We divide that $500 by $1000 to arrive at the gross margin ratio of 50% (after multiplying by 100 to get a whole number percentage)
Importance of gross margin
Gross margin is a very important metric to help entrepreneurs and operators understand their business in several ways. Gross margin gives you:
Insight into profitability
Gross margin is the foundation of a good bottom line. In order for a business to bring home a solid profit, there needs to be plenty of cushion between COGS and sales so that indirect costs (like rent, utilities, and marketing) can be covered. Monitoring gross margin regularly can help businesses identify areas where they can reduce costs or increase prices to boost profitability. Depending on the granularity of your cost data, you may also be able to track margin for individual product lines, giving you a clearer picture of which products contribute most to overall profitability and which ones may be holding you back.
Help with pricing decisions
In addition to providing insight into profitability, the gross margin also plays a vital role in pricing decisions. When setting prices for products or services, businesses need to consider not only the costs of production but also the profit margin they want to achieve. By analyzing the gross margin, companies can determine whether their prices are too high or too low and adjust accordingly. For example, if a company's gross margin is lower than the industry average, it may need to raise prices to improve profitability.
Help with cost control
Gross margin can also help you with cost control. By keeping track of COGS, businesses can identify areas where they may be overspending and take steps to reduce costs. For example, if a company's gross margin has declined over time, it may need to renegotiate supplier contracts or find ways to streamline production processes. By focusing on cost control, businesses can improve their gross margin and increase their profitability over the long term.
What is contribution margin?
Contribution margin is a key financial metric that enables businesses to determine the profitability of their products or services. This metric represents the difference between the sales revenue generated by a product or service and the variable costs incurred directly to produce or deliver it. These variable costs may include raw materials, labor costs, and shipping expenses, among others.
Let's say a software company sells a subscription-based service for $1,000 per year. The variable costs involved in delivering this service, such as server expenses and customer support costs, total $200 per subscription. In this scenario, the contribution margin for each subscription would be $800, which is the revenue of $1,000 minus the variable costs of $200. This means that the company has $800 left to pay for fixed expenses like salaries, rent, and utilities.
By analyzing the contribution margin for different offerings, businesses can identify the most profitable products or services and allocate resources accordingly. For instance, if the contribution margin of a particular product is relatively low, the business may decide to discontinue that product or optimize it to increase profitability. Overall, contribution margin enables businesses to make informed decisions and optimize their operations to boost profitability.
Contribution margin calculation
The formula for contribution margin is:
Revenue - Variable costs = Contribution margin
As you can see, the formula is similar to the gross margin formula, with the difference being variable costs replacing COGS. Let’s look at variable costs and why they matter for this calculation.
One key aspect of COGS is direct vs. indirect costs. Only those directly related to producing and delivering the product or service are included in the COGS number. Now we’re taking a look at variable vs. fixed costs. The difference here is that variable cost changes with each additional unit produced. In the first example of a bakery, the ingredients would increase for each additional cake baked. The baker's salary, however, would remain fixed regardless of the number of cakes (as long you don’t reach a volume that requires hiring an additional baker).
That brings us to the other key difference between these two metrics. Gross margin is typically measured as a percentage of the entire company or line. Contribution margin is measured for each individual unit and is often expressed as a dollar amount. So if one SaaS subscription sells for $1000 with $200 in variable costs, the contribution margin per subscription would be $800. As the name suggests, $800 per unit contributes to fixed overhead costs, and once those are covered, it contributes to profits.
As you’re thinking about fixed and variable costs, you may think of examples that are mixed, or partially variable. An example could be direct labor. It doesn’t cost you any more for your employees to make an extra unit, but at some point (maybe every 6,000 units produced per month) you’ll need to add one more salaried employee to your production line. You can include those costs in your variable costs on a per-unit basis.
Importance of contribution margin
Contribution margin is a very helpful tool for understanding your unit economics and how each sale impacts your business. Contribution margin can:
Help with break-even analysis
This is the key function of contribution margin. By calculating how much each unit contributes, you can determine exactly how many units you need to sell in order to cover your operating costs and break even. With that information, you can decide if the product or business is viable and create a plan to reach that break-even point. For example, if you sell a product for $80 with a variable cost of $30, you have a $50 contribution per unit. If your monthly fixed overhead costs are $10,000, you need to sell 200 units per month to break even. After that, your contribution margin will represent profit.
Contribution margin and CAC
Understanding contribution margin can also inform how you view your customer acquisition cost (CAC). When you know how much each individual sale contributes to your overhead and profits, you’ll have a better understanding of how much you can afford to spend to acquire a new customer. For instance, if it costs you $100 in ad spend to get a new customer, and the product you sell will have a $20 contribution margin, you’ll need to sell 5 units before you’ve covered your acquisition cost. If your customer isn’t likely to buy 5 units from you or buy additional products once they’ve become your customer, you’ll need to find a way to lower CAC or increase the value of orders. If you haven’t already, make sure you calculate CAC, so you can make informed decisions here.
Help with decision-making
It also allows you to compare the unit economics of each product to see which are contributing the most to your business and which may be barely breaking even or possibly even losing you money.
Provide insight into profitability
Like gross margin, contribution margin gives you another way of looking at profitability. This metric makes it easy to see how sales volume will impact profitability and how much your expenses will fluctuate with the increased sales.
How to use the gross margin & contribution margin calculator
As we just saw, gross margin and contribution margin are similar but different. By using direct costs, gross margin reveals the gross profit percentage of the company as an overall measure of health and allows you to track progress and compare against industry benchmarks. By focusing on variable costs, contribution margin shows how much each individual unit contributes toward fixed costs and profits, and how sales volume impacts profitability.
One thing both numbers have in common is that they can both be easily calculated using our free calculator below. Simply input the numbers for your business, and you’ll see your results instantly—no need to log in or go to another page.
Contribution margin calculator
Contribution Margin Calculator
Do your products contribute to your success?
By focusing on variable costs, contribution margin shows how much each individual unit contributes toward fixed costs and profits, and how sales volume impacts profitability.
Contribution Margin Ratio
The contribution margin calculator is provided for informational purposes only and is not intended to provide specific legal, financial, accounting, or tax advice. This tool is provided on an "as is" basis and makes no representations or warranties of any kind, express or implied, as to the accuracy or completeness of the information provided. We encourage you to seek the advice of professionals regarding all finance issues.
Gross margin calculator
Gross Margin Calculator
How healthy is your profit margin?
By using direct costs, gross margin reveals the gross profit percentage of the company as an overall measure of health and allows you to track progress and compare against industry benchmarks.
Gross Margin Ratio
The gross margin calculator is provided for informational purposes only and is not intended to provide specific legal, financial, accounting, or tax advice. This tool is provided on an "as is" basis and makes no representations or warranties of any kind, express or implied, as to the accuracy or completeness of the information provided. We encourage you to seek the advice of professionals regarding all finance issues.
Gross margin and contribution margin both give you a clearer picture of profitability in your business in different ways, overall and on a per-unit basis. You can use both of these metrics to make better decisions and grow your business in a healthy, sustainable way.
Want to learn more about gross margin and contribution margin? Here are some commonly asked questions about these metrics:
How do I find contribution margin per unit?
Contribution margin is typically expressed on a per-unit basis, but you may not have easy access to the right numbers. If you don’t have per-unit costs available at your fingertips, don’t worry. If you’re wondering how to find contribution margin per unit, first calculate the margin based on net sales and variable costs for a period of time (a month, for example), then divide by the number of units sold to get a per-unit dollar amount.
What is the contribution margin per unit formula?
The standard formula for calculating contribution margin is:
Revenue - Variable costs = Contribution margin
Whether this is per unit or overall for a certain product depends on the revenue and cost numbers you use, but it's typically measured per unit and expressed as a dollar amount rather than a percentage.
How do I calculate contribution margin ratio?
In some cases, you may want to see the contribution margin ratio rather than the raw dollar amount per unit. To calculate it, you need to subtract the variable costs from the revenue and divide that number by the revenue.
What’s the difference between gross margin vs EBITDA?
Gross margin represents the percentage of revenue that a company retains after deducting the cost of goods sold, while EBITDA stands for earnings before interest, taxes, depreciation, and amortization, and represents a company's operating profitability.
While both metrics can help evaluate a company's profitability, they differ in their scope and focus. Gross margin is a measure of the efficiency of a company's production process and its ability to manage costs, while EBITDA focuses on a company's operating performance and its ability to generate profits from its core business operations. Ultimately, the choice between these two metrics depends on the nature of your business and what you’re trying to measure.
What’s the difference between gross margin vs operating margin?
Gross margin represents the percentage of revenue that remains after subtracting the cost of goods sold, while operating margin is the percentage of revenue that remains after subtracting all operating expenses, including the cost of goods sold, salaries, rent, and other expenses.
While both metrics are used to evaluate a company's profitability, gross margin is focused solely on the cost of goods sold, while operating margin takes into account all operating expenses, even those that can’t be directly attributed to production.
Operating margin provides a more comprehensive view of a company's profitability and efficiency in managing its costs. However, gross margin can be useful for companies with a high cost of goods sold relative to other operating expenses, such as manufacturing companies.
What’s the difference between gross margin vs gross profit?
The terminology around gross margin can be confusing, especially when terms are used interchangeably (we’re even guilty of that in this blog post!) Gross profit is commonly used to refer to the raw dollar amount of margin between COGS and revenue, which is the same as gross margin. However, many people use the term gross margin (as we’ve used it above) to mean gross margin ratio, which is simply taking this raw dollar amount and dividing it by the revenue or net sales number to arrive at a percentage.
Can you measure gross margin per unit?
Yes, it is possible to measure gross margin per unit. To calculate the gross margin per unit, you would first determine the total cost of producing one unit of a product, including the cost of materials, labor, and any other expenses directly related to production. Then, you would subtract the cost per unit from the unit price to arrive at the gross margin per unit. It can be useful for pricing decisions, but, since gross margin doesn’t take into account variable costs vs fixed costs, it’s not as helpful as contribution margin for determining things like break-even point.
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Josh Richards is an editor at Pipe, where he writes about investment, finance, accounting & other existing & emerging payment methods and technologies.
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