Contribution Margin vs. Gross Profit

Making Profits

Business is about the business of profitability. It is about figuring out a way to make money from selling a product or offering a service. Analysts are constantly trying to come up with ways to increase the bottom line (net income); contribution margin and gross margin are two metrics they use to help do it.

Margin

The term "margin" is meant to read "as a percent of sales." That is, gross profit margin is gross profit "as a percent of sales," and operating profit margin is operating profit "as a percent of sales." Contribution margin is a little different.

Contribution Margin

Contribution margin is a concept used by cost accountants to determine the profitability of products. It is much like gross profit, however it is a study at the unit level instead of the gross level. Contribution margin reads as "per unit of sale."

Connection

Analyzing contribution margin can give some insight into how to improve gross margin, especially when there's only one product line. Every product has a different contribution margin, and those products with higher contribution margins should be heavily promoted.

Complications

Contribution margin is an academic concept; that is, it is based on a model that is less complicated than the real world. However, gross profit is very real and used as a practical measure of a company's viability.

Bottomline

All business models can benefit from looking at contribution margin to gain valuable insights about ways to improve gross profit. The former looks at the business model from a micro perspective, and the latter from a gross perspective. The more simplistic the business model, the better the correlation.

References

• Investopedia: Contribution Margin
• Investopedia: Gross Profit Margin