Contribution Margin Vs Operating Margin: What Are the Differences?

Contribution margin and operating margins are both profitability measures. However, both these metrics provide different types of information to the business.

Both these terms have certain similarities and some key differences. Let us discuss these concepts briefly.

What is Contribution Margin?

The contribution margin is total sales minus variable costs for a company. It can be calculated for a unit of product, a batch of products, or collectively for the business.

The contribution margin is the ratio of “contribution” to revenue. The term contribution refers to the profit that is achieved after covering variable expenses only.

The contribution margin basically does not include fixed costs in its calculations. Therefore, only variable costs are included to obtain it. Variable costs can be direct or indirect, however, mostly direct variable costs are included in these calculations.

The contribution margin can be expressed in dollar values or it can be converted into a percentage figure.

Contribution margin serves many benefits to the company. It allows a company to analyze direct (variable) costs of production.

Then, it helps a company understand the gross profitability of a product line. It can be particularly useful when launching new product lines.

It also helps a business understand the profitability margins. It means a business can use this formula to analyze the revenue left to cover fixed costs.

In short, contribution margin can be a good starting point for any business. After deducting variable expenses, a business can allocate the remaining revenue to cover fixed costs and generate profits.

Formula

The contribution margin can be calculated in a few ways.

Contribution Margin = Net Sales – Variable Costs

Contribution Margin = Net Income + Fixed Costs

The margin ratio can be calculated as:

Contribution Margin Ratio = (Net Sales – Variable Costs)/Net Sales

Variable and Fixed Expenses for Contribution Margin

Understanding the difference in calculations of the contribution margin is important. Unlike other profitability concepts, it considers only variable costs.

The concept says fixed costs are often one-time expenses that do not contribute directly to the costs of production. For instance, a building constructed for the production facility is a large one-time expense.

The building cost would remain the same regardless of the level of production. Even if the company produces zero products the cost is already sunk.

READ:  Non-Sufficient Fund (NSF) Checks – All You Need to Know Including Journal Entry!

Therefore, the only logical cost of production remains the variable cost. Variable costs are often direct expenses such as direct material, direct labor, and energy costs that are all linked with the production level.

Importance of Contribution Margin

The contribution margin can be used as a starting point for product costing, pricing, and sales analysis. It leads us to break-even analysis for a product, product line, and business.

This concept also helps a business differentiate between fixed and variable costs and their impacts on different products.

Once a company covers all the direct and variable costs, it can then analyze to cover its fixed costs. In turn, it helps a company set the right selling price that can cover its fixed costs and generate sufficient revenues.

The contribution margin also helps a company in keeping its product prices competitive with its competitors in the market.

What is Operating Margin?

Operating margin is the ratio of operating income to the sales of a company. It calculates the revenue after deducting operating and non-operating expenses but without interest and tax costs.

Operating margin considers variable costs of production as well as some indirect costs such as administration expenses of the company. It is the ratio of the operating profit that is the profit before paying interest and taxes.

It takes the concept of contribution margin to the next step by deducting some non-operating expenses. Therefore, it offers a refined profit margin indicator as compared to the contribution margin.

Operating Income

Operating income is the revenue minus operating expenses of a company. It is the revenue generated by a business from its operations directly.

In other words, operating income refers to the sales generated through production of products (or offering services).

Operating income represents the core activity of a business. Therefore, it offers a good analysis point to creditors and lenders to assess the profitability of the business.

Formula

Operating margin is a ratio and it can be expressed in a percentage term using the following formula.

Operating Margin = (Operating Profit/Revenue) × 100

Importance of Operating Margin

Generally, the higher the operating margin ratio the better it is for the business. It indicates the operating profitability of the business.

It is a snapshot of the operations of a company. It quickly tells investors, creditors, and lenders about the operating efficiency of the business.

READ:  Accounting for Joint Venture – US GAAP Rules

If a business can generate sufficient profits from its core operations (excluding other sources of income), it is considered a stable business.

Also, when a business keeps a consistent or growing operating margin ratio over the years, it is a positive indicator for analysts.

A higher operating margin and a consistent ratio over the years mean fewer financial and operating risks for the business.

A higher operating margin is also a good indication of efficient operations of the business. However, it may also increase by controlling non-operating expenses and improving pricing.

Non-operating costs like admin and marketing expenses also play an important part in the calculations of the operating margin. Therefore, controlling these expenses would also affect the margin ratio.

The limitation of the operating margin is that it does not account for working capital changes. It is only an accounting concept that has little practical implication for the business itself.

When comparing operating margins, analysts must consider businesses within the same industry and also scale them to their sizes.

Contribution Margin Vs Operating Margin – Key Differences

Contribution margin and operating margin are both profitability metrics. Both these terms can be expressed in dollar values or percentage terms.

These ratios provide useful analyses points that can help a business in different ways. There are a few similarities and some key differences in both concepts.

Let us summarize these details here.

Definitions

The contribution margin is revenue minus the variable costs of a business. These variable costs can be direct or indirect expenses.

Contribution margin is a managerial costing concept that considers the contribution of a product or product line rather than gross profit.

Operating margin is the ratio of operating profit to revenue. Operating profit or operating income is total revenue minus operating and non-operating expenses.

Operating margin includes variable and fixed costs. However, it excludes interest and tax costs from its calculations.

It is a financial accounting concept that considers conventional financial accounting metrics.

Calculations

The contribution margin can be calculated by the formula:

Contribution Margin = Net Sales – Variable Costs

It can also be expressed in percentage terms:

Contribution Margin = (Net Sales – Variable Costs)/Net Sales × 100

READ:  How to Calculate Contribution Margin and its Ratio?

The operating margin can be calculated by the formula:

Operating Margin = (Operating Profit/Revenue) × 100

Pros and Cons of Contribution Margin

Contribution margin is a managerial accounting concept. It is simple to understand and easy to calculate.

It considers only variable costs that are often direct costs. It excludes fixed costs from the profitability analysis as these are large and one-time costs.

It can be used as a starting point in the costing, pricing, and efficiency analysis of the business.

Some limitations of the contribution margin include the exclusion of fixed costs that may be direct in nature. For instance, a company spending a large amount on purchasing a new production machine would be considered a fixed cost in the contribution margin analysis.

Pros and Cons of Operating Margin

Operating margin is a good indicator of the operating efficiency of the business. It can help a company understand the impact of operating costs and compare them with non-operating costs.

Operating margin includes fixed costs as well unlike the contribution margin analysis. It is also a simple financial accounting concept and easier to understand by managers and analysts.

A drawback of the operating margin is the exclusion of important profit contributors like depreciation, interest, and tax expenses. These factors can have a significant impact on the profitability of a business.

Uses for the Business

Contribution margin offers a valuable starting point to a business in profitability analysis.

It also helps a company identify the profitability or margin per product in a product. It is can be very useful for businesses producing similar products with a large number of product lines.

Investors and analysts would also keep an eye on the prime product line profitability of the business.

On the other hand, operating margin is an efficiency metric. It tells a business how much revenue it is generating from its core operations.

It gives a business an idea of generating sufficient revenue that covers all operating costs. The operating income can then be used to cover its non-operating costs such as interest, taxes, and depreciation.

Scroll to Top