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17/04/2018 07:56:34 PM

What is the difference between Contribution Margin and Gross Margin

Contribution margin is especially useful because it provides insight into the profit potential of a company. Contribution marginis the excess of sales over variable costs, as shown below.

Contribution Margin = Revenues - Variable Costs

Gross margin measures how much a company can charge for its products over and above the cost of acquiring or producing them, as shown below.

Gross  margin=Revenues-Cost of goods sold

Companies, such as branded pharmaceuticals, have high gross margins because their products provide unique and distinctive benefits to consumers. Products such as televisions that operate in competitive markets have low gross margins. Contribution margin indicates how much of a company’s revenues are available to cover fixed costs. It helps in assessing risk of loss. Risk of loss is low (high) if, when sales are blow, contribution margin exceeds (is less than) fixed costs. Gross margin and contribution margin are related but give different insights. For example, a company operating in a competitive market with a low gross margin will have a low risk of loss if its fixed costs are small.

Consider the distinction between gross margin and contribution margin in the context of manufacturing companies. In the manufacturing sector, contribution margin and gross margin differ in two respects: fixed manufacturing costs and variable nonmanufacturing costs. The following example (figures assumed) illustrates this difference:

Contribution Income Statement Emphasizing Contribution Margin (in 000s)

Revenues

 

$1,000

Variable manufacturing costs

$250

 

Variable nonmanufacturing costs

270

520

Contribution margin

 

480

Fixed manufacturing costs

160

 

Fixed nonmanufacturing costs

138

298

Operating income

 

$182

 

Financial accounting income statement emphasizing gross margin (in 000s)

Revenues

$1,000

Cost of goods sold ($250 + $160)

410

Gross margin

590

Nonmanufacturing costs ($270 + $138)

408

Operating income

$182

 

Fixed manufacturing costs of $160,000 are not deducted from revenues when computing contribution margin but are deducted when computing gross margin. Cost of goods sold in a manufacturing company includes all variable manufacturing costs and all fixed manufacturing costs ($250,000 + $160,000). Variable nonmanufacturing costs (such as commissions paid to salespersons) of $270,000 are deducted from revenues when computing contribution margin but are not deducted when computing gross margin.

Like contribution margin, gross margin can be expressed as a total, as an amount per unit, or as a percentage. For example, the gross margin percentageis the gross margin divided by revenues—59% ($590 / $1,000) in our manufacturing-sector example.

One reason why gross margin and contribution margin are confused with each other is that the two are identical in the case of merchandising companies. That’s because cost of goods sold equals the variable cost of goods purchased (and subsequently sold).