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Gross Margin vs. Contribution Margin: What's the Difference?

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Synopsis:

Gross margins and contribution margins of a company help with its profit assessment. However, there are certain differences between the two that you should be aware of. So, here’s your gross margin vs contribution margin guide.

Understanding Gross Margin

Here is everything you need to know about gross margin:

  1. The gross margin is the same as the gross profit margin

  2. The gross margin includes revenue and direct production costs only

  3. Operating expenses like sales, marketing costs, taxes, etc are not included in the gross margin

  4. Gross margin uses direct labour and materials costs but not administrative costs

  5. Direct production costs of a company include the cost of goods sold (COGS), raw materials, labour, etc 

  6. With the help of the gross margin, one can determine how efficiently a company is generating its revenue via direct costs like direct labour and materials costs. 

Defining Contribution Margin

Here is everything you need to know about contribution margin:

  1. The contribution margin of a company can be defined as the figure obtained when the variable costs of a company are subtracted from its revenue

  2. With the help of the contribution margin, the profitability of individual items produced and sold by the company can be measured. 

  3. The contribution margin also helps analyze the variable costs that are included in the production of each item.

Key Differences Between Gross Margin and Contribution Margin   

Here are the key differences between gross margin and contribution margin

Aspects

Gross Margin

Contribution margin

Implementation

Analyzed across the company with the help of financial reports

Analyzed per unit/product to determine how much profit from each product can be used to cover its fixed costs

Users

Users who are more interested in the overall profitability of a company depend on the gross margin. This could include investors, lenders, government agencies, etc

Users interested in determining the costs they can control when manufacturing individual goods use the contribution margin. This can include the company’s management team

Expenses Taken into Account

Includes all costs of a company like goods sold. These costs can be both fixed and variable.

Since the contribution margin has fewer costs, it will always, likely be higher than the gross margin

Transparency

The net income of the company is the same in both cases

The net income of the company is the same in both cases

Reporting Requirement

Not explicitly required when presenting financial statements of a company externally. However,  internally, total revenue and the cost of goods sold need to be included in the financial statement, thus containing the gross margin

Companies do not have to separate the fixed expenses from variable costs, so the contribution margin is not needed when reporting externally

How to Calculate Gross Margin 

Here are the steps to calculating the gross margin:

  1. Gross margin is calculated by deducting the cost of goods sold or COGS from revenue

  2. Post this deduction, the result is then divided by the revenue of the company

  3. The next step involves the result obtained from step 2 to be multiplied by 100 to help find a percentage.

Here COGS=Cost of goods sold

How to Calculate Contribution Margin  

Here are the steps to calculate the contribution margin:

  1. The contribution margin ratio is usually expressed as a percentage 

  2. However, companies can calculate the currency amount of the contribution margin to understand the per-rupee attribution to the variable cost.

  3. The contribution margin can be obtained by subtracting the variable costs of a company from its net sales revenue.

Below is the formula:

Contribution Margin=NSR−VC

Here NSR=Net sales revenue and VC=Variable costs

Importance of Gross Margin in Business

The gross margin helps determine the financial health of a company. It measures production and business efficiencies. Below is a list of why the gross margin is important in business:

  1. Helps provide critical information on production return on investment:

  • Helps with cost control. 

  • Changes can highlight problems in the supply chain. 

  • Helps determine if any processes need adjustments to improve productivity. 

  • A drop in gross margin could indicate a decline in productivity. 

  1. Helps inform pricing:

  • Help develop pricing strategies 

  • Analysis of gross margins can help reach an ideal pricing strategy and ensure higher profits

  1. Helps measure business efficiency:

  • Comparing monthly income statements and the gross margin can help determine a company's efficiency 

  • If margins are rising it indicates growing efficiencies. 

  • If margins are declining, it indicates inefficiencies. 

  • Declining margin can also be a sign to reconsider lowering prices of commodities to increase sales

Importance of Contribution Margin in Business

Below is a list of why the contribution margin is important in business:

  1. Helps businesses decide on the pricing for their products or services. The contribution helps identify products or services with higher profitability.

  2. Helps companies figure out the profitability offered by different product lines. As a result, companies can then focus on promoting and expanding these product lines.

  3. With the help of contribution margin, businesses can identify where they need to cut down on variable costs without affecting profitability. 

  4. Businesses can determine the sales volume needed to help cover all costs and reach the break-even point with the help of the contribution margin. Post this analysis, setting sales targets becomes easier.

Conclusion:

Both the gross margin and contribution margin of a company help with profit assessment. Under the gross margin umbrella come all costs of a specific product. Under the contribution margin umbrella, however, only the variable costs of a particular product or service are included. A company’s gross margin can help determine how profitable a product is while the contribution margin helps determine how efficiently the company can cover its fixed costs.

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

For All Disclaimers Click Here: https://bit.ly/3Tcsfuc

Frequently Asked Questions

What is Gross Margin?

Answer Field

The gross margin is the same as the gross profit margin and includes revenue and direct production costs only. It is the percentage obtained after direct expenses of a company like labour and materials have been deducted from the company’s revenue.

What is the Contribution Margin?

Answer Field

A company’s contribution margin can be defined as the figure obtained when the variable costs of a company are subtracted from its revenue. It helps determine the profitability of individual items produced and sold by the company.

How do Gross Margin and Contribution Margin differ?

Answer Field

One of the main differences between the gross margin and the contribution margin is that while on the one hand, the contribution margin counts the variable costs, the gross profit margin counts all the costs that a company incurs to sell its product or services.

Why is the Contribution Margin crucial for decision-making?

Answer Field

The contribution margin helps companies evaluate how profitable an individual product, service or business area is.

Why is understanding Gross Margin important for a business?

Answer Field

With the help of the gross margin, companies can get help when it comes to price setting of particular products or services

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