If you are running a company, it’s no doubt you are after reaping profits. And there is a need to understand the financial health and performance of your business. Also, you should understand how profitable that business is. Only two financial ratios can help you understand; contribution margin and profit margin.
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First off, gross margin is the amount of money available after deducting the cost of goods from the net sales (revenues). In contrast, the contribution margin is the amount available after deducting total variable costs from total sales. These amounts can be converted into rations or percentage.
Contribution margin aims to measure if a company is handling its production efficiently and keeping the production costs at a low level. Gross margin, on the other hand, aims at estimating the financial performance and health of the company.
The significant difference between gross margin and contribution margin is the composition of the costs included while calculating them. Gross margin includes all the costs, whereas contribution margin excludes fixed overhead costs.
Let’s study each one separately.
Gross margin is used to determines the company’s profitability. You arrive at it when you subtract the cost of goods sold (COGS) from the revenues.
If you want to make it in a ration form, you divide the answer by the revenues. Important to note, COGS comprises of the production costs only, that is, both variable and fixed production costs.
One unique feature of the COGS is that it’s always specific to only expenses that are directly used in producing a particular product or service. It eliminates administrative costs such as wages, rent, among others.
Companies find gross margin useful in measuring their preliminary profitability before deducting their overhead costs and eventually used to calculate operating and net income.
Let’s take an example in a table.
|Credentials||Amount in $|
From the table above, the gross margin becomes the initial step in analyzing sales before subtracting the operating expenses, such as interest on loans, tax expenses, and advertising costs.
To be on the safe side, you should ensure that the gross margin is high so that it can cover all expenses. If the gross margin becomes negative, that means you are operating on losses.
It’s calculated by taking the sale price of a product or service minus the variable cost per price. This type of financial ratio scrutinizes how an individual product contributes to the profit of the company.
While calculating the contribution margin, you only include the variable costs. The reason fixed costs are ignored is that they’re production-related costs.
More importantly, contribution margin offers a direct path in finding the breakeven point of your sales.
Just to mention, the break even point is the point where a company should operate to generate significant profits. If you run on a higher contribution, you should celebrate because that means you can make profits quickly due to the increased sales. Apparently, the higher the sales, the more you are offsetting the fixed costs.
Just as a reminder, fixed costs don’t change, no matter how the company makes its sales- they remain the same. Some good examples include rent, taxes, and salary to employees.
In contrast, variable cost keeps changing depending on the sales. If sales increase, they increase too, and vice versa. Some common examples include electricity bills and sales commissions.
An Illustration of Gross and Contribution margin
In the year 2019, XYZ company recorded net sales of $500,000. The opening and closing inventory of goods remained the same quantity. The cost of goods sold amounted to $350,000, where $150,000 were variable costs and the remaining portion fixed costs. The selling and administrative costs amounted to $120,000, where $50,000 were variable costs, and the remaining were fixed costs.
XYZ’s Contribution Margin will be Net sales-Variable costs
Therefore $500,000-$150,000-$50,000= $300,000
The contribution margin ratio will be $300,000 divided by $500,000(net sales)
=0.6, which is equal to 60%.
XYZ’s Gross Margin= net sales-cost of Goods
Therefore $500,000-$350,000= $150,000
The Gross margin percentage will be $150,000 divided by $500,000(net sales)
Summary of Gross Margin Vs. Contribution Margin
|Gross Margin||Contribution margin|
|It’s given by deducting the cost of goods sold from sales.||It’s given by deducting the total variable cost from the sale price.|
|Its formula is (Revenue-COGS)/Sales.||Its formula is (Sales-Variable costs)/Sales.|
|It aims at determining if the sales can offset the costs of production.||It aims to determine the pricing. A low or negative contribution margin serves as a red light in that line of production.|
|When calculating, it includes all costs: both fixed and variable costs.||It only includes variable costs when performing the calculations.|
|Best suitable when calculates the company’s history or projecting specific sales value.||Best suitable for dealing with multiple scenario analysis.|
|It only analyzes the total profit metric.||It only analyzes the profit metric per item.|
Both gross margin and contribution margin are useful in determining the profitability and cost-effectiveness of any entity. The management should take these margins seriously so that the profitability is kept stable and margin impact maintained. In case of recessions, the management should ensure that they do all they can to ensure the margin maintains: for example, applying cost-cutting techniques.
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