When you’re deciding which companies to invest in, one of the most important factors to consider is the profitability of each company. A company’s gross margin and contribution margin are two methods of measuring how efficiently the business uses its resources and how profitable its goods and services are.
This article will compare gross margin and contribution margin and explain what each metric tells you about a company.
What Gross Margin Tells You About a Company
Gross margin is a company’s gross profit—or revenue minus the cost of goods sold—divided by its total revenue. Gross margin is synonymous with gross profit margin and represents the percentage of a company’s revenue that’s left over after you account for the cost of sales.
A company’s gross margin can be an indicator of how efficiently it uses its resources. In general, a higher margin is better because it means a greater percentage of revenue is left over for the company’s other operating expenses, and ultimately, its net profit margin.
There’s not necessarily one “good” gross margin that companies should strive for. It depends largely on the industry and the size of the company. A high gross margin might not necessarily mean a company is performing well, while a low gross margin might not mean a company is performing poorly.
It’s important to remember that gross margin doesn’t include all of a company’s expenses. It only includes the cost of goods sold, which includes the cost of materials, labor, and overhead directly related to production. It doesn’t take into account plenty of other expenses such as marketing and sales, management salaries, accounting, and other administrative costs.
Because the gross margin only looks at a snapshot of a company’s financials, investors should look at the firm’s other expenses to see what the margin really means. A company with a high gross margin but high administrative costs might actually be worse off than a company with a low gross margin but few other expenses.
There are two ways investors can use gross margin as a useful measuring stick. First, compare a company’s gross margin with that of other companies in the industry. For example, comparing the gross margin of Wells Fargo to that of Starbucks might not tell you anything, but comparing Wells Fargo’s gross margin to Bank of America’s might be more useful.
The other way you can use gross margin as a benchmark is to compare a company’s gross margin from year to year. A drastic increase in gross margin from one year to the next could be a red flag.
How To Calculate Gross Margin
To calculate a company’s gross margin, you’ll first need two other numbers: its revenue and its cost of goods sold. Revenue is the income received from the sale of a company’s goods or services. The cost of goods sold is the sum of all direct costs that went into producing a company’s goods and services.
The formula for gross margin looks like this:
Gross Margin = (Revenue - Cost of Goods Sold) / Revenue
Suppose you were calculating the gross margin of a fast-food restaurant. Over the course of a year, the restaurant sells $1 million worth of food—that’s its total revenue. At the same time, the cost of the ingredients, hourly wages, and equipment used to make the food comes to $500,000—that’s the cost of goods sold.
Now that we know the company’s revenue and cost of goods sold, we can find its gross profit by subtracting $500,000 cost of goods sold from $1 million, for a total of $500,000.
Once you know the company’s gross profit, you can divide it by the total revenue to find the gross margin. Next, we divide the $500,000 profit by the $1 million revenue. Because the gross margin is expressed as a percentage, we find that the fast-food operation has a gross margin of 50%.
Here’s what the entire formula looks like:
Gross Margin = ($1 million - $500,000) / $1 million
When calculating the gross margin of a company, all the information you need can be found in the top three lines of its income statement. The first line of the income statement is the company’s revenue, the second line is its cost of goods sold, and the third line is its gross profit.
What Contribution Margin Tells You About a Company
Contribution margin is a percentage that represents the profitability of a particular product by subtracting the variable expenses of producing it from the revenue it creates and dividing the difference by the revenue.
Variable expenses only include those that change depending on the volume of units of a product or service. These expenses can include raw materials, production supplies, hourly wages, commissions, and more. Contribution margin doesn’t include fixed costs such as utilities, salaries, rent, etc.
Contribution margin is used most often by companies to help them determine which products are most profitable. Using this information, they can determine which products to keep and which to stop producing. They also may use contribution margin to make pricing decisions, as a low contribution margin might indicate the company needs to raise its prices.
But investors can also use contribution margin to compare two different companies. Suppose you were deciding whether to buy shares of PepsiCo or Coca-Cola Co. To help you with your decision, you could compare the contribution margin of each company’s flagship product: Pepsi and Coca-Cola. If one of these drinks has a significantly larger contribution margin than the other, it could be a sign that the company uses its resources well.
Similarly to gross margin, a company’s contribution margin alone isn’t necessarily a good indicator of its overall financial health. While a company might have a high contribution margin, that number doesn’t reflect the company’s bottom line. After all, a company with a good contribution margin might overspend on its fixed costs, resulting in a poor net profit margin.
How To Calculate Contribution Margin
To calculate the contribution margin of a product, you first must know the sales revenue and variable costs for a particular product. Once you know those numbers, you complete a formula that’s similar to the one for gross margin:
Contribution Margin = (Net Sales Revenue - Variable Costs) / Sales Revenue
Suppose you wanted to calculate the contribution margin of two different products from your local clothing boutique. You find out that the company’s scarves sell for a retail price of $15 each, and they sell roughly 1,000 scarves per year, resulting in a sales revenue of $15,000 per year. You also find that it costs about $5,000 in variable expenses to produce those 1,000 scarves, for a total of $5 per scarf.
You can use those numbers to calculate the product’s contribution margin with the following formula, determining that the contribution margin for that scarf is about 67%:
Contribution Margin = ($15,000 - $5,000) / $15,000
Next, you want to calculate the contribution margin of the same boutique’s sundresses. The dresses create more revenue and result in about $35,000 in annual revenue (or 1,000 dresses for $35 each). But the variable costs to produce those dresses total $17,500. Using the formula above, you find that the dresses have a contribution margin of about 50%. So even though they produce more revenue than the scarves, they ultimately have a smaller margin.
Calculating contribution margin might be more difficult for individual investors because you don’t necessarily have all the information you need. Public income statements don’t always break down the revenue and expenses for each individual product line, nor do they separate the variable expenses of producing goods or services from the fixed expenses. Relying on the cost of goods sold isn’t enough, because that figure can include fixed expenses. As a result, internal company documents may be necessary to complete this calculation.
Gross Margin vs. Contribution Margin: What’s the Difference?
Gross margin and contribution margin are both measurements of the profitability of a particular business. The primary difference between the two is that while gross margin represents the profitability of the company’s entire operations, contribution margin is most often used to calculate the profitability of a single product or product line.
Another difference between gross margin and contribution margin is what each factors in to its respective calculation. The formula for contribution margin includes only variable expenses. The formula for gross margin considers the cost of goods sold, which can include both fixed and variable expenses.
The final difference between the two is what they’re most often used for. Gross margin can be used to learn how cost-efficient a company’s production is. In other words, how well does it use its resources? Contribution margin is more often used to make decisions by companies themselves. It can be used to compare the profitability of two different products to determine which products are no longer worth producing.
|Gross Margin||Contribution Margin|
|Gross Margin = (Revenue - Cost of Goods Sold) / Revenue||Contribution Margin = (Net Sales Revenue - Variable Costs) / Sales Revenue|
|Used to calculate the profitability of a company’s operations||Used to calculate the profitability of a particular product or product line|
|Considers the cost of goods sold, which includes both fixed and variable costs||Considers only variable costs|
The Bottom Line
Gross margin and contribution margin are both metrics to help measure the profitability of a business. Gross margin is the profitability percentage of a company’s entire operation, while contribution margin measures the profitability of one particular product.
As an investor, you can use both to determine the profitability—and therefore the financial health—of a particular business. But neither percentage should be used as your sole source of data to make investing decisions. Instead, it’s also important to consider the company’s overall profit margins.