Question

Please comment on the post below

Yes, I agree. In CVP analysis, gross margin is a less-useful concept than contribution margin. Because gross margin is the difference between the cost to produce or purchase an item and its selling price. Gross margin is the amount before deducting expenses such as selling, general and administrative and interest. There is a big difference between gross margin and net profit margin.

Contribution margin is defined as revenues minus variable expenses. The contribution margin reveals how much of a company’s revenues will be contributing after covering the variable expenses to the company’s fixed expenses and net income. The contribution margin is also a key component in computing a company’s break-even point.

A company might use budgeted costs rather than actual costs to compute direct labor rates because it’s difficult to trace direct labor costs when completing work.

Answer 1

CVP stands for Cost, Volume, Profit analysis. In simple terms it is the analysis of cost and profit for a particular volume of product. Weightage should be given on the term cost. In contribution margin, cost is either variable or fixed. It is a more holistic approach. Variable and fixed costs includes all type of cost irrespective of the fact that they are manufacturing or non manufacturing. Contribution margin is arrived after deducting total variable costs from the revenue unlike Gross margin which is arrived after deducting all type of manufacturing costs and overheads (fixed or variable) from the revenue. So decision taken under contribution margin method are more accurate and close to reality. It does not distinguishes between company's expenditure on various departments and the net income arrived under this method represents the global income of the company. Unlike gross margin method where step down method is used to arrive at departmental profits first and then the global profit of the company at last. Contribution margin method assumes that all the outflows of the company from production of goods to dispatch to the consumers are cost to the company in that particular year. It is a more realistic approach than carrying forward the costs (manufacturing and non manufacturing overheads) under Gross margin method. That is why we can say that contribution margin is a better approach for CVP analysis than gross margin.