Contribution Margin Versus Gross Margin

Learning Objective 9 Distinguish contribution margin from gross margin

revenues minus all variable costs
revenues minus cost of goods sold

So far, we have developed two important concepts relating to profit margin—contribution margin, which was introduced in this chapter, and gross margin, which was discussed in Chapter 2. Is there a relationship between these two concepts? In the following equations, we clearly distinguish contribution margin, which provides information for CVP and risk analysis, from gross margin, a measure of competitiveness, described in Chapter 2.

$\begin{array}{rcl} Gross margin & = & Revenues - Cost of goods sold \\ Contribution margin & = & Revenues - All variable costs \end{array}$

The gross margin measures how much a company can charge for its products over and above the cost of acquiring or producing them. Companies, such as brand-name pharmaceuticals producers, have high gross margins because their products are often patented and provide unique and distinctive benefits to consumers. In contrast, manufacturers of generic medicines and basic chemicals have low gross margins because the market for these products is highly competitive. Contribution margin indicates how much of a company’s revenues are available to cover fixed costs. It helps in assessing the risk of losses. For example, the risk of loss is low if the contribution margin exceeds a company’s fixed costs even when sales are low. 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 manufacturing sector. The concepts differ in two ways: fixed manufacturing costs and variable operating (nonmanufacturing) costs. The following example (figures assumed) illustrates this difference:

Two tables illustrate the difference between gross margin and contribution margin.

The first table is a contribution income statement emphasizing contribution margin (in thousands). The details of the table are as follows:

1. Revenues: 1,000 dollars

2. Variable manufacturing costs: 250 dollars and Variable operating (nonmanufacturing) costs: 270 dollars, for total of 520 dollars

3. Contribution margin: 480 dollars

4. Fixed manufacturing costs 160 dollars and fixed operating (nonmanufacturing) costs: 138 dollars, for total of 298 dollars

5. Operating income: 182 dollars

The second table is a financial accounting income statement emphasizing gross margin (in thousands). The details of the table are as follows:

1. Revenues: 1,000 dollars

2. Cost of goods sold (variable manufacturing costs, 250 dollars plus fixed manufacturing costs, 160 dollars), total: 410 dollars

3. Gross margin: 590 dollars

4. Operating (nonmanufacturing) costs (variable, 270 dollars plus fixed, 138 dollars), total: 408 dollars

5. Operating income: 182 dollars

Fixed manufacturing costs of $160,000 are not deducted from revenues when computing the contribution margin but are deducted when computing the gross margin. The cost of goods sold in a manufacturing company includes all variable manufacturing costs and all fixed manufacturing costs $inline style ($ back space text 250,000 end text thin space plus thin space $ text 160,000 end text right parenthesis space of -0.1em begin inline style straight. end style$ The company’s variable operating (nonmanufacturing) costs (such as commissions paid to salespersons) of $270,000 are deducted from revenues when computing the contribution margin (because these are variable costs), but are not deducted when computing gross margin (because cost of goods sold only includes manufacturing costs).

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 percentage is the gross margin divided by revenues—59% $inline style left parenthesis $ 590 divided by $ text 1,000 end text right parenthesis$ in our manufacturing-sector example.

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