Contribution and gross margin help to understand the gap between revenue and expenses of the business. These measures are used to assess the profit that the firm generates.
Contribution margin has been widely used by firms. All the variable costs are deducted from the revenues to get the contribution margin. It does not include the fixed overhead costs to be subtracted from the revenues. The logic behind this idea is that managers can only control a variable portion of the cost. Hence, their performance should be assessed on the basis of contribution margin. Generally, contribution margin is used to measure product wise profitability.
On the other hand, gross profit is a traditional technique in this regard, it’s calculated by deducting all the costs (variable + fixed) from revenue. So, it’s a business-wide profitability measure.
Further, it’s important to note that all of these costs are the direct costs charged in the cost of goods sold in the profit and loss statement.
Why do companies use contribution and gross margin?
Firms use contribution margin to assess the estimates of how much their sales efforts are fruitful in generating revenues, neglecting the fixed costs which remain unchanged with the volume of sales. However, both methods generate the same amount of profit in the end. So, the difference in gross and contribution margin only helps to add in analysis.
In the initial stage of calculation, the contribution margin seems to be higher but the firm still has to pay the fixed cost. So, in the end it becomes equal to the profit calculated by gross profit way.
The contribution margin is calculated by subtracting only the variable costs of sales from the revenues. It then involves the cost of direct material, variable overhead costs, and commission expense, excluding all the fixed costs from the cost of goods sold.
While calculating the contribution margin, only the costs that change with the change in the volume of sales are included in the cost of goods sold. The logic behind the idea is that performance of the managers/products should be assessed on the basis of costs that can be controlled by them.
For instance, to run a production area there is a minimum number of personnel required who are not directly affected by the production. Hence, these should not be included in the margin calculation. Negligence of the fixed cost makes the contribution margin show a higher percentage of profits by neglecting fixed costs. Firms typically use this method to better assess the effectiveness of the firm’s sales efforts.
Gross margin is a classic technique for determining the profitability of goods and services after selling them. It is obtained by subtracting the cost of goods sold from the revenues. Here, the cost of goods sold is a collection of various variable costs as well as fixed costs. Variable costs are the costs that can depend on the number of sales. However, fixed costs are fixed and are independent of the sales volume. These costs usually include direct labor, direct material, and overhead costs.
Gross contribution formulas are shared below to get a practical insight into these methods!
How to calculate contribution margin
The contribution margin can be calculated by subtracting total variable costs from net sales. In terms of the accounting formula, the contribution margin is equal to;
Contribution Margin = Net Sales – Total Variable Expenses
Contribution ratio formula
Another formula to calculate contribution margin is by taking the ratio of total revenue minus variable costs over total revenue. It can be represented as;
Contribution margin = (Total revenue – variable cost) / Total revenue
Gross Margin Formula
The gross margin ratio is calculated by subtracting the cost of goods sold from net sales and then dividing it by the net sales. It can be represented as;
Gross margin = (Net sales – the cost of goods sold) / Net sales
Here, the cost of goods involves both variable and fixed costs.
Difference between Contribution Margin and Gross Margin
Both the margins are used to know the profitability of the goods and services, but there is a clear difference between the two methods. That major difference is the exclusion of fixed overhead costs from the contribution margin. This implies that the contribution margin would be greater than the gross margin because of the less costs involved. However, when we exclude fixed costs from the contribution margin, both methods show the same profit in the end.
The gross margin is usually considered a traditional approach because it includes an element of the fixed cost. Hence, it does not precisely reflect the outcomes of the sales efforts that the company managers incorporate.
In simple words, the fixed overhead costs are included in the calculation of gross margin. So, the plus point of gross margin is that it reflects a better view of the earnings a company is making from the sales of its goods and services.
Similarly, the Contribution margin percentage tends to be higherbecause when you subtract the revenues from the cost of goods sold, it does not include certain costs. Because of the fewer costs involved in contribution, it tends to give a greater value than the other one. Many firms have switched to this method because it gives a realistic estimate of how much the firm’s efforts related to sales are generating profits. Firms that use this method make a separate classification of fixed overhead costs lower down in the income statement.
Eventually, the total profits of the company come out to be the same using both methods. It is just for the convenience of the business activities’ analysts to choose whatever method they desire.
Gross and contribution margins have significant importance in terms of profit analysis.
So, if the firm uses gross margin or contribution margin, both will eventually lead it to the same profit with the same number of sales. The only difference is that the gross margin involves all the costs under its cost of goods sold section, while the contribution margin only includes variable costs.