Lets explore the difference between Gross Margin and Contribution Margin and then learn how to calculate our breakeven sales or breakeven volume using Contribution Margin.
Gross Margin is the amount of money left after subtracting all of the direct costs of production from all revenue. It is calculated as:
Gross Margin = Total Sales - Total Direct Costs of Production (Cost of Goods Sold).
Gross Margin would include variable and fixed costs that are directly related to production such as raw materials and direct labour.
Contribution Margin is the amount of money left after subtracting variable costs from revenue per unit of item. It is calculated as:
Contribution Margin = Selling Price Per Unit - Variable Costs Per Unit.
Contribution Margin excludes the fixed costs associated with production. It seeks to measure what is left when an extra unit of product is sold.
Contribution Margin enables Business Managers make decisions on issues like additional production, discounts, raw material inventory, etc.
Now lets explore a Case Study.
Arinze has a small factory in Owerri where they produce uniforms for a school.
The fabric, threads and other accessories used to produce each uniform costs N3,000 but each uniform is sold to the school at N6,000.
Arinze’s company has 10 permanent staff with monthly salaries as indicated below:
1 CEO – N100,000;
5 tailors - N30,000 each;
2 Business Developers – N50,000 each;
1 Admin Assistant – N30,000; and
1 Cleaner – N15,000.
In May 2020, Arinze’s company supplied 200 units of uniforms to the school.
Other costs incurred in the business in the month were:
Equipment Depreciation (N5,000)
Furniture Depreciation (N2,000) and
Now let us calculate their Gross Margin and Operating Profit for the month and also the Contribution Margin for each unit of uniform sold.
Revenue is calculated as:
Selling Price x No. of Units Sold = N6,000 x 200units = N1,200,000
Cost of Goods Sold (COGS) is calculated as:
(Material Cost/Unit x No. of Units Sold) + (Direct Labour Costs) + (Equipment Depreciation Costs) = (N3000 x 200units) + (5 x N30,000) + N5,000
Gross Profit is calculated as:
Revenue - COGS = N1,200,000 - N755,000 = N445,000.
Personnel Costs is calculated as:
Total of all non-direct Labour Costs i.e. employees that are not involved in production of the uniforms including the CEO, Business Developers, Admin Assistant and Cleaner.
Personnel Costs = N100,000 + (2 x N50,000) + N30,000 + N15,000 = N245,000
Now, lets calculate the Gross Margin and Contribution Margins.
We already calculated the Gross Profit above.
Gross Margin = Gross Profit ÷ Revenue = N445,000 ÷ N1,200,000 = 34%
Contribution = Selling Price - Variable Costs = N6,000 - N3,000 = N3,000.
Contribution Margin = Contribution ÷ Selling Price = N3,000 ÷ N6,000 = 50%.
Contribution Margin is always higher than or equal to Gross Margin.
In Part 2, we'll explore how to use Contribution Margin to calculate our Breakeven Point.