The essential difference between the contribution margin and gross margin is that fixed overhead costs are not included in the contribution margin. This means that the contribution margin is always higher than the gross margin. The classic measure of the profitability of goods and services sold is gross margin, which is revenues minus the cost of goods sold. The cost of goods sold figure is comprised of a mix of variable costs (which vary with sales volume) and fixed costs (which do not vary with sales volume).
Typical contents of the cost of goods sold figure in the gross margin are:
- Direct materials
- Direct labor
- Variable overhead costs (such as production supplies)
- Fixed overhead costs (such as equipment depreciation and supervisory salaries)
An alternative to the gross margin concept is contribution margin, which is revenues minus all variable costs of sales. By excluding all fixed costs, the content of the cost of goods sold figure now changes to the following:
- Direct materials
- Variable overhead costs
- Commission expense
Most other costs are excluded from the contribution margin calculation (even direct labor), because they do not vary directly with sales. For example, a certain minimum crew size is needed to staff the production area, irrespective of the number of units produced, so direct labor cannot be said to vary directly with sales.
The gross margin concept is the more traditional approach to ascertaining how much a business makes from its sales efforts, but tends to be inaccurate, since it depends upon the fixed cost allocation methodology. The contribution margin concept is the recommended method of analysis, since it yields a better view of how much money a business actually earns from its sales, which can then be used to pay off fixed costs and generate a profit.
In general, the contribution margin tends to yield a higher percentage than the gross margin, since the contribution margin includes fewer costs. This can lead to an erroneous assumption that a company's profitability has surged, when all the business has done is switch from the gross margin method to the contribution margin method, thereby shifting all fixed costs into a separate classification lower down in the income statement. In fact, total company profits are the same, no matter which method is used, as long as the number of units sold has not changed.