Question

The concepts of gross margin and contribution margins are two important measures companies can use to determine how well they are faring in terms of profit-making. While gross margin is simply revenue less the total cost of the goods sold, contribution margin is revenue, less variable costs. According to Datar and Rajan (2018),

“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 gives 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.”

What other insights or observations do you have with regard to gross margin and contribution margin? Do those insights change depending on the industry sector being considered; if so, why?

Your initial posting should be 250-500

Answer 1

To understand the insights and observations regarding gross margin and contribution margin, let us first understand what these terms means:

• GROSS MARGIN indicates how much a seller gets from the amount of sales revenue after deducting the direct costs (Direct cost is a cost which can be economically identified and assigned to a particular salable unit) associated with buying a product or producing a product.
• By formula, as given, Sales - Cost of goods sold = Gross Margin
• Cost of goods sold includes both fixed as well as variable cost.

• CONTRIBUTION MARGIN Is nothing but the sales less the variable cost (Variable cost is the cost which tends to vary with the level of activity more or less proportionately) of the product.
• By formula, as given, Sales - Variable cost = Contribution margin.

Let us come at different insights and observations about gross margin and contribution margin.

1. The foremost observation one can make is that contribution margin does not include fixed cost including fixed overheads associated with buying or manufacturing a product. Whereas, gross margin includes fixed cost. As a result, Contribution margin stands always higher than the gross margin.This may lead to an erroneous assumption that the company's profitability has increased whereas the fact is company has just shifted itself from gross margin to contribution margin method.  

2. Sometimes the insights change depending upon the nature of a company. Say, it is observed that the calculation of contribution margin did not consider even the direct cost associated with manufacturing or buying a product.

• For example, say, a company produces a product in a factory where a minimum staff of 10 people is required in production area irrespective of number of units produced. In such a case, direct cost of labour cannot be said to vary directly with sales and hence, for purpose of calculating contribution margin, one may not consider such cost.
• But, for gross margin calculation all the costs associated with that product will be considered giving more clear picture to the observer of the cost of the goods produced.

3. The gross margin concept is a historical approach and may not provide exact and most appropriate results because it   includes allocation of fixed cost. However, contribution margin which considers only variable cost can appropriately provide the amount that a company possess to pay off its fixed cost.

4. The intention of the contribution margin calculation in a company which is highly diversified and is engaged in production of number of products is not to encompass measure of company's profitability but, it intends to evaluate the earnings on a particular product and how such earning can be increased by either decreasing its variable cost or increasing its sales price. In companies producing many products like Reliance industries, the fixed cost becomes irrelevant for the purpose of decision making regarding change in pricing of that particular product.    

5. Gross margin is a total profit metrics that is the total profit earned by a company on all the products manufactured/bought and sold by it. However, contribution margin is typically the profit earned by a company on any one of its products that is contribution margin is per item profit metrics.

6. In the small or mid sized companies, which are engaged in 2-3 products, the allocation of the fixed cost becomes very important. An analysis as to which product contributes more to the fixed cost stands as one of the vital deciding factors in producing or closing off that particular product. Let us understand this with an example.

• Say a company produces 3 Products A, B and C. The factory has a capacity to work 1000 man hours and approximately 10000 total number of units can be produced. in such a case, where capacity is restricted and defined, a product which has a highest contribution margin subject to demand shall be produced more out of the three products to increase the profitability of a company. Here, fixed cost shall remain same irrespective of number of units of each product produced. Hence, the deciding factor will be contribution margin.
• More the contribution margin, more is the capacity of a company to pay its fixed cost and more will be the retaining after deducting all cost.
• It can be clearly seen that, in such cases, if the company takes decisions based upon gross profit margin, it may not earn the optimum level of profit. But, these insight will differ where company is thinking to open a new factory and in such cases, fixed costs and gross margin calculation shall also to be given due importance.

Thus, these were some of the analytics about contribution margin and Gross margin and we can conclude that many of these insights may change depending upon the industry sector, size of the business, nature of the business etc.