Definition of Gross Margin
Some use the term gross margin to mean the same as gross profit, which is: net sales minus the cost of goods sold. Others use the term gross margin to indicate the gross profit as a percentage of net sales.
The cost of goods sold will consist of both fixed and variable product costs. However, selling, general and administrative expenses (SG&A) are not part of the cost of goods sold.
Definition of Contribution Margin
Contribution margin is defined as net sales minus both the variable product costs and the variable SG&A expenses. The contribution margin can also be expressed as a percentage of net sales. In that case it is often described as the contribution margin ratio.
Information for Examples
Let’s assume that a company had the following amounts during the past year:
- Net sales of $600,000
- Cost of goods sold of $320,000 ($120,000 variable + $200,000 of fixed)
- Inventories did not increase or decrease
- SG&A expenses of $190,000 ($40,000 variable + $150,000 fixed)
Example of Gross Margin
The company’s gross margin is: net sales of $600,000 minus the cost of goods sold of $320,000 = $280,000. The gross margin or gross profit percentage is: gross profit of $280,000 divided by net sales of $600,000 = 46.7%.
Example of Contribution Margin
The company’s contribution margin is: net sales of $600,000 minus the variable product costs of $120,000 and the variable expenses of $40,000 = $440,000. The contribution margin ratio is 73.3% ($440,000 divided by $600,000).
