Gross Margin vs Contribution Margin in Pricing Decisions

The decision “this product is loss-making, let’s stop selling it” is sometimes based on a gross profit table. But gross profit includes fixed production overheads shared out to products using an allocation base. Much of that cost stays the same whether or not the product continues to be sold. Stopping a product that shows a gross loss can therefore reduce the company’s total profit rather than increase it.

This article explains the difference between the two measures and which one to use for which decision.

Definitions

Measure	Calculation	Costs included
Gross profit	Net revenue − Cost of sales	Direct materials, direct labour, production overheads (fixed and variable, allocated)
Contribution margin	Net revenue − Variable costs	Costs that change with sales volume: raw materials, packaging, variable energy, sales commission, freight, etc.
Contribution margin ratio	Contribution margin ÷ Net revenue	—

Variable costs are not limited to production. Sales-related costs such as commission, freight and channel discounts are also part of the contribution calculation.

Hypothetical example

Hypothetical example — not based on a real company.

A manufacturer has two products. Fixed production overheads (rent, depreciation, fixed staff) are allocated to products on direct labour hours at TRY 150 per hour. Both products need 2 direct labour hours per unit; direct labour cost is included in the variable production cost line. Selling costs such as commission and freight are not part of production cost; they are shown on a separate line.

Per unit (TRY)	Product A	Product B
Selling price	1,000	600
Variable production cost (materials, direct labour, variable energy)	(560)	(300)
Variable selling cost (commission, freight)	(60)	(30)
Contribution margin	380	270
Allocated fixed production overhead (2 hours × 150)	(300)	(300)
Product result after full cost	80	(30)
Memo: Gross profit (revenue − production cost)	140	0

Management looking at the full-cost table sees Product B as loss-making, and its gross profit is zero. Yet Product B generates TRY 270 of contribution with every sale. If B is discontinued, the TRY 300 of fixed cost allocated to it does not disappear; it is reallocated to other products. The company loses the TRY 270 of contribution per unit of B, and total profit falls.

This does not mean Product B is fine. The right questions are these: could the capacity B uses earn a higher contribution from another product, and can B’s price be raised over time to cover its share of fixed costs?

Which measure for which decision?

Decision	Measure to use	Reason
Additional order / special discount (spare capacity)	Contribution margin	Fixed costs do not change; the effect equals the contribution
Dropping a product	Contribution margin + avoidable fixed costs	Fixed costs that disappear with the product are also included
Product priority at a capacity bottleneck	Contribution per unit of the bottleneck (e.g. per machine hour)	The scarce resource goes to the product earning the most from it
Long-term price list	Full cost (production cost and operating expenses)	All costs must be recovered in the long run
Statutory reporting, inventory valuation	Gross profit (production-cost basis)	For entities applying TFRS, TMS 2 (the Turkish equivalent of IAS 2) requires fixed production overheads to be allocated to inventory based on normal capacity

Hypothetical example — not based on a real company.

Bottleneck note: When capacity is limited, look at contribution per unit of the scarce resource rather than per product. If Product A uses 2 machine hours and Product B uses 1, contribution per hour is TRY 190 for A and TRY 270 for B. Prioritising B therefore makes better use of capacity.

Implementation steps

1. Classify costs as variable or fixed: Determine the behaviour of each cost line in the chart of accounts. Separate semi-variable costs, such as energy, using historical data.
2. Calculate variable costs by product: Use bills of materials, scrap rates and sales-related costs.
3. Report contribution by product, customer and channel: The same product earns a different contribution in different channels because of discounts and freight costs.
4. Track fixed costs separately: Lay out the contribution report so that it shows how much of total fixed cost has been covered.

Common mistakes

• Treating the fixed overhead allocation as the product’s “true” cost.
• Leaving sales commission, freight and discounts out of variable costs.
• Selling at low prices indefinitely because contribution is positive. If total contribution does not cover fixed costs, the company makes a loss.
• Calculating contribution with outdated costs in an inflationary environment. Current replacement costs should be used.

What it means for management

Gross profit and contribution margin answer different questions. Statutory reporting requires production cost; long-term pricing requires full cost. Product, customer and capacity decisions should be made on contribution margin. Presenting the two views side by side in the same report puts the “loss-making product” debate on a sounder footing. For more, see the articles on product profitability analysis and activity-based costing.

Sources last checked: 21 October 2026