The primary objective of any commercial business entity is to generate profit for its owners or stockholders. Thus, management efforts and policy making are often directed towards maximization of profits. In this effort, management utilizes several profitability indicators and ratios to assess the profitability of the business operations and to guide their decision making.
This article looks at meaning of and differences between two key types of profitability indicators– gross profit and contribution margin.
Definitions and meanings
Gross profit (also referred to as sales profit and gross income) is the income earned by the entity from its manufacturing and trading operations and is calculated by drawing up a trading account. It assesses how efficient an entity is while utilizing its resources (supplies and labor) for the production of goods or the provision of services.
Manufacturing entities incur direct costs that are specifically related to the production process and indirect costs that are related to other processes and functions such as selling process, administrative process, marketing process etc. Merchandising entities also incur direct costs that are specifically related to procurement of goods for resale to customers.
Gross profit is a measure of the profit earned from sale of its products after considering all direct costs incurred in the manufacturing or procurement process. These costs are primarily direct variable costs but also include allocated fixed costs that are directly related to the production process such as rent of the factory, depreciation of plant and machinery, fixed salaries and wages of production supervisors and workers etc.
The formula for calculation of gross profit is:
Gross profit = *Sales – Cost of goods sold
*Net of sales returns and sales discount
For entities in service industries, gross profit is derived by subtracting from the service revenue all basic costs essential to provide services to clients.
Gross profit is reflected at the first level in the entity’s income statement. Subsequently, all indirect costs and indirect incomes are recorded to calculate the net profit earned during the period.
Contribution margin is the amount of revenue earned by a product in excess of its associated variable costs. This excess revenue earned by the product represents its contribution towards the recovery of fixed costs incurred, giving it the name ‘contribution margin’.
The formula for calculation of contribution margin is:
Contribution margin = Sales – Variable costs
Businesses incur both variable and fixed costs. Variable costs are those costs which are dependent on the level of production whereas fixed costs are those that are incurred irrespective of the level of production. In order for a business to be profitable, it should earn enough revenue so as to cover both its variable and fixed costs. Contribution margin indicates the per unit amount that the sale of each product generates as contribution towards recovery of fixed costs.
M/s ABC manufactures pens and pencils in its factory. Its pens are sold at $2 per unit with an associated variable cost of $1.2 per unit. Its pencils are sold at $1.5 per unit with an associated variable cost of $0.5 per unit.
The pen’s contribution margin works out to $0.80 per unit whereas that of pencils works out to $1 per unit.
Therefore, although the pens have a higher selling price their contribution to recovery of fixed costs is lower owing to higher variable costs making it less profitable than pencils which actually have a lower selling price.
As highlighted in the example, contribution margin helps management understand the relative profitability of its different products. Determining contribution margin helps in identifying break even point of sales i.e.: volume of sales after which the entity starts generating profits. This can help management take pricing decisions as well as decide on appropriate product mix so as to maximize overall profitability.
Difference between gross profit and contribution margin:
The notable points of difference between gross profit and contribution margin have been listed below:
- Gross profit is the income earned by an entity from its manufacturing/procurement operations after considering its manufacturing/procurement costs.
- Contribution margin is the per unit income earned from sale of a product after consideration of its variable costs.
- Gross profit represents the entity’s profitability from its main manufacturing/procurement operations.
- Contribution margin represents the income contribution made by each product to the recovery of fixed costs of the entity.
- Gross profit is calculated after deducting cost of goods sold from net sales revenue of the entity.
- Contribution margin is calculated after deducting per unit variable costs from the per unit selling price of each product.
- Gross profit is a macro level profitability indicator – it measures profitability of the entity’s operations as a whole (limited to manufacturing/procurement activity).
- Contribution margin is a micro level indicator – at it is calculated at a per unit level for each product.
5. Nature of costs considered
- Gross profit calculation considers only direct production related costs. These can be both variable costs as well as production related allocated fixed costs.
- Contribution margin on the other hand considers both direct and indirect costs related to a product, but considers only those costs that are variable in nature.
6. Disclosure in financial statements
- Gross profit is disclosed in the profit and loss account that form part of financial statements of an entity.
- Contribution margin is a calculation done my cost accountants and reported in internal management reports. It does not find any separate disclosure in the financial statements.
- The purpose of calculating gross profit is to assess the efficacy and profitability of the entity’s manufacturing operations.
- The purpose of calculating contribution margin is to assess the individual and relative profitability of the entity’s different products.
8. Applicability to entity type
- Gross profit calculations are relevant primarily in manufacturing and merchandising entities as it is concerned with production related revenues and costs.
- Contribution margins are relevant for all type of entities – manufacturing, trading and service entities.
Conclusion – gross profit vs contribution margin:
Gross profit and contribution are both profitability indicators that are used by management for various analysis. Gross profit although indicates profitability, does not give a complete picture as it only considers manufacturing/procurement costs. An entity with high gross profit may end up with low net profit if it incurs high indirect costs. Gross profit analysis is useful for management to understand the efficacy of its manufacturing operations and to take measures for cost control of production costs. Contribution margin is an important tool which helps management in prioritizing efforts towards products that earn higher margins and are thus more profitable.