The Relative Importance of Both Gross Profit and Contribution Margin
Gross profit, or gross margin, and contribution margin are both measures of the difference between sales and the cost of producing a product. Gross margin is calculated as sales minus costs of goods sold, and contribution margin is calculated as sales minus all variable costs. While both figures are useful, they are useful for different reasons. Understanding the relative importance of the two margins can help you choose the right one for the analysis you are working on.
Gross Profit - External Reporting
Gross profit is a standard measure used when companies produce financial statements for external users. Because generally accepted accounting principles have strict rules regarding recognition of revenue and the costs that make up product costs, gross profit figures are fairly standardized across companies. Decisions that can affect the calculation of gross profit, such as the choice between first-in, first-out or last-in, first-out inventory cost flow assumption, are required to be disclosed in the footnotes to the financial statements. This allows financial statement users to take notice of these differences when comparing companies.
Gross Profit - Internal Use
Because gross profit is a standard metric on financial statements that are required for external users, management may be tempted to use gross profit as an internal measure of profitability. However, this may not be advised. Small-business owners should recognize that gross profit may be inflated solely due to increased production. Because accounting rules require that fixed costs of production, such as rent or insurance, are included in inventory costs, when high levels of inventory are produced and not sold in the same period, these costs are deferred until the goods are sold. This can make companies look more profitable than they actually are during periods of increasing inventories and less profitable than they actually are during periods of decreasing inventories.
Contribution Margin - CVP Analysis
Cost-volume-profit analysis is a technique used by company management to examine how changes in either cost, volume or profit affect the other two quantities. A key to this analysis is the contribution margin. Because the contribution margin only considers variable costs, the ratio of costs to sales stays the same as sales levels change. In addition, the stability of the contribution margin ratio implies that the ratio of variable costs stays the same as well. These relationships help small-business owners to calculate break-even points, the effect of advertising campaigns and pricing changes without having to recast an entire income statement.
Contribution Margin - Variable Costing
Management looking to analyze company profit may wish to use variable costing techniques to do so. Unlike traditional GAAP costing methods, variable costing uses contribution margin instead of gross margin. By not assigning fixed costs to inventory, production levels do not affect net income, giving small-business owners a stable picture of changes in net income. Because this method requires the company to prepare two sets of financial statements, owners may wonder if the difference between using gross profit under traditional costing and contribution margin under variable costing is significant. The difference between the two figures grows for two reasons. First, the difference increases as the difference between selling and production within the accounting period increases. Second, the difference increases as the proportion of fixed production costs increases.
- Managerial Accounting: Ray H. Garrison, et al.
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