Pricing, costs and profitability · Fictional example
Gross margin, contribution margin and net profit: three different numbers
Short answer: gross margin subtracts the cost of goods sold; contribution margin subtracts all relevant variable costs; net profit considers the remaining expenses for the period. They are not interchangeable.
Three measures, three different business questions
Gross margin
How much revenue is left after the cost of goods or services sold? Gross profit equals revenue minus cost of goods sold. The gross margin percentage divides that gross profit by revenue.
Contribution margin
How much remains after costs that change with activity, available to cover fixed costs and contribute to profit? It equals revenue less all relevant variable costs, including variable selling costs outside COGS.
Net profit
What accounting result remains after the other expenses and charges for the period? This includes operating costs, finance costs and applicable taxes. It is not cash in the bank.
An important distinction: «cost of goods sold» is an accounting classification; «variable cost» describes cost behavior. They do not always match. If COGS includes fixed production overhead, you cannot calculate contribution simply as sales minus COGS.
One small shop, three very different percentages
Suppose a shop sells 100 units at USD 20. To keep the arithmetic transparent, its cost of merchandise sold is entirely variable (USD 9 per unit), it incurs USD 3 variable selling cost per unit, USD 600 fixed operating expenses, and USD 100 other expenses and taxes. This fictional example assumes no other expenses.
| Item | USD | Meaning |
|---|---|---|
| Revenue: 100 × 20 | 2,000 | Starting point |
| Merchandise sold: 100 × 9 | −900 | COGS (all variable in this example) |
| Gross profit | 1,100 | 55% of revenue |
| Other variable selling costs: 100 × 3 | −300 | Excluded from COGS |
| Total contribution | 800 | 40% of sales; USD 8 per unit |
| Fixed operating expenses | −600 | Do not vary directly with each unit |
| Other expenses and taxes | −100 | A simplified assumption |
| Net profit | 100 | 5% of sales |
On USD 2,000 revenue, gross profit is USD 1,100, contribution is USD 800 and net profit is only USD 100. A 55% gross margin is not a 55% net profit, and neither figure tells you how much cash is available.
Formulas you can reproduce
- Gross margin (%) = (revenue − COGS) ÷ revenue × 100 = 1,100 ÷ 2,000 × 100 = 55%.
- Contribution margin (%) = (revenue − all variable costs) ÷ revenue × 100 = (2,000 − 900 − 300) ÷ 2,000 × 100 = 40%.
- Net profit margin (%) = net profit ÷ revenue × 100 = 100 ÷ 2,000 × 100 = 5%.
Which number helps with which decision?
- Before offering a discount: calculate unit contribution before and after; more sales can still mean less money available to cover overhead.
- When examining costs: separate direct, variable selling and fixed expenses; inspect why gross profit and net profit are so different.
- When watching cash survival: trace actual collections and payments. Positive accounting profit does not prove sufficient liquidity.
What this calculation cannot prove
This is not an accounting audit or a diagnosis of your business. Actual margins depend on product mix, returns, taxes, inventory, allocation of fixed manufacturing costs, commissions and period definitions. Services and manufacturers may classify COGS differently.
Bring a specific decision to the table
The Express Advisory in Business Finance covers cash flow, budgeting and profitability; the Commercial Strategy advisory addresses offers and sales channels. The published price is USD 100 per advisory, with 2–3 hours of total work depending on the topic and a recommendations report.
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For a discount decision, compare our worked example on discounts and extra units. For liquidity, read why cash can fall as sales rise.
Sources and method
The contribution formulas follow the OpenStax managerial accounting explanation. Gross profit, contribution and period net profit use different cost categories; this illustration explicitly defines its assumptions.
· Original fictional illustration by the JFCarpio.com team. No customer data or claimed client outcomes.