Gross margin vs contribution margin can be an excellent metric to understand business profitability potential.
What is Gross margin?
Gross margin is about profit strength of the business. It helps understand if business operations are economically viable or there is a need to improve gaps in the production/purchase.
If your business is about production – you need to buy the raw material, process purchased raw material with labour and equipment. The cost incurred in this process to make a product is deducted from revenue to come at a Gross profit (the cost deducted can be fixed/variable). It means if you need to improve gross profit, there are two ways as given,
- Increase sales price of the products – It’s an excellent choice. However, it may not be possible because of competition and market dynamics.
- Control DIRECT cost – the cost can be controlled via an efficient purchase of raw material, effective labour management, enhanced production management, and innovation in the process.
Example of Gross margin
Consider the following details for the business of Blue-tech Company Limited.
| Particulars | USD per unit |
| Revenue | 12 |
| Direct material | (4) |
| Direct labour | (3) |
| Gross profit | 5 |
It’s important to note that we’ve deducted all the direct costs from revenue. If we analyze the detailed breakup of this cost, we note two types of costs in these ledgers. These costs include fixed and variable.
Uses of gross margin
Following are some of the uses of gross margin.
- It helps understand the extent of production profitability. In fact, it can be a good idea to compare gross profit with a competitor. It should be helpful in understanding business position in terms of purchase and production.
- It’s extremely helpful for an investor looking to buy the business. It helps them in evaluating business potential and scalability.
- It’s helpful matric in setting product price strategies. For instance, if gross profit is higher, the company has the potential to lower prices and win the competition. In fact, increased sales with a lower price might lead to a reduced margin in terms of percentage. However, it might be massive in absolute numbers. So, the right use of Gross profit margin can be value-adding in the process of setting price.
- Gross margin helps understand the cash profile of the business. The business with a higher GP is expected to utilize low working capital as cash generated with sales can be used to meet operational expenses. Hence, it’s a favorite area of investors.
What is the contribution margin?
Contribution margin refers to incremental money generated via completion of the sales cycle. It’s about deducting all variable costs from revenue generated.
The contribution margin is calculated to understand the behaviour of variable costs associated with the unit sales. If the contribution margin is higher, sales operations have a higher potential to bear fixed costs without converting to loss. On the other hand, if the contribution margin is lower, a slight fixed cost increase can covert operations into a loss.
So, the science behind the idea of contribution margin is ‘’business needs to focus on controlling variable cost associated with the production process’’.
Example of contribution margin
Consider the following details for the business of Sun-tech Company Limited.
| Particulars | USD per unit |
| Revenue | 12 |
| The variable cost of material | (5) |
| Variable cost of labour | (2) |
| Variable cost of machinery | (2) |
| Variable selling and admin expenses | (1) |
| Contribution margin | 2 |
Note
We have deducted all the variable costs; these costs are related to production and non-production as well.
Uses of contribution margin
Following are some of the uses for contribution margin.
- This matric can help identify profitable products – priority can be set in terms of higher contribution generating product. It’s extremely helpful when a business needs to decide production plan with limited capacity (throughput accounting).
- Low contribution products can be eliminated. It helps to improve an overall business profitability. In fact, a business can decide if they need to optimize production via innovation or make it machine-incentive.
- It’s one of the major components of relevant costing.
Conclusion on gross margin vs contribution margin
Gross profit margin is about profit operations of the business. It’s calculated by deducting all direct costs from revenue earned. The comparison of gross margin with other companies helps understand if there are gaps in the purchase of raw material or inefficiency in the production process.
Usually, direct cost is one of the major components of the business. Hence, if the business is able to control it, things can be very different and profitable.
On the other hand, contribution margin is about ”contribution achieved with completing the sales cycle. It considers variable cost in the decision to rank product profitability. It’s calculated by subtracting all the variable costs from the product’s selling price.
Further reading on gross profit and contribution margin.
