If you want to unlock profitability for your business and want to increase the potential of your business, then you must know about Contribution Margin and Gross Profit Margin. These concepts are a bit tricky for all business owners.
Today in this article we will guide you to completely know about Contribution Margin and Gross Profit Margin and will guide you to calculate break even in a proper way. In order to get complete knowledge about Contribution Margin and Gross Profit Margin, you have to read the article till the end. Thus it will make sure that you know about these two concepts and also know how to calculate the break even in a proper way.
Table of Contents
What Is Contribution Margin And Gross Profit Margin?
If your main aim is to earn a large amount of profit in your business, then you must know the concept of Contribution Margin and Gross Profit Margin.
These two concepts will definitely lead you to “Unit Economics”. Unit Economics will help you to study the past of your business easily and effectively so that you don’t make any mistakes in the future to increase your profit. You will be able to make decisions based on the datas of your business.
You can easily find out the sources that cause profit to your business and thus you can focus your salespeople to those sources and invest more marketing efforts to those sources to earn more and more profit.
Let us have a look at some of the definitions and learn about Contribution Margin and Gross Profit Margin.
Gross profit margin or you can say Gross Margin includes revenue after deducting the costs incurred only on direct production that is the direct material costs or the direct labor costs It excludes other costs like sales and marketing expenses.
Direct production costs are also known as the Cost of Goods Sold (COGS). So you can calculate the gross margin:
Gross MArgin = Net Sales – COGS /Net Sales.
Net Sales are the total sales that sales return, allowance, and discounts.
Net Sales = Gross Sales – Sales Return – Allowance – Discounts
The amount of money that is left after deducting the Cost of Goods (COG) from the revenue earned by selling those goods, is known as Gross Profit. The amount of money or the direct cost required for the production of goods is known as the Cost of Goods (COG). The Gross Profit can be represented in both Dollars and Percentages.
The amount of money or the revenue that is left after deducting both the direct and indirect costs. The amount of money or the costs that are not directly related to the income earned but are related to the job or the customers is known as Variable Indirect cost.
When the company reaches a point where the sales of the company become profitable after meeting fixed costs, that point is known as the “Break Even Point”. When the company reaches the break-even point and then the revenue contributes to the profits you earned, those revenues are known as Contribution margins. The contribution margin is helpful in determining the operational strategies.
When you represent Contribution margins in the form of amounts, percentages, and ratios, you will get a lot of information and data about the structure of sales and the process of calculating the pricing and commission.
Contribution Margin = NSR – VC. NSR means Net sales revenue and VC means Variable Costs
You will be able to collect all the data and then based on that data you have to optimize the prices, adjust your payment, analyze individual jobs of the employees, analyze products, services, and customers, and adjust employee incentive structure.
This information and actions will help you to make effective decisions to increase the profit of your company.
How To Calculate Contribution Margin And Gross Profit Margin?
Now to calculate the contribution margin you have to deduct the cost which is dependent on the amount of product or the products sold i.e. the Variable cost from the revenue earned by selling those products. Mathematically the Contribution Margin is represented as,
Revenue – Variable Costs = Contribution Margin
This mathematical representation can be modified and adjusted to give a clear picture of each and every component of the business. It can also be represented as a percentage or ratio.
Now to calculate the Gross Profit Margin you have to divide gross profit by total sales. Mathematically the Gross Profit Margin is represented as,
Gross Profit / Total sales = Gross Profit Margin
In order to represent both Contribution Margin and Gross Profit by mathematical representation, you can write
Total revenue – Cost of Goods Sold = Gross Profit
Gross Profit – Variable costs = Contribution Margin
Both Contribution Margin and Gross profit are very useful tools that can be used to find out a lot of information in order to unlock the profitability of the company.
How To Calculate Contribution Margin Per Unit
When you calculate the Contribution Margin Per Unit, you will be able to find out the Contribution Margin per unique item, per unique service, and per unique customer. Mathematically the Contribution Margin Per Unit can be represented as,
Sales of particular item or service or customer – Variable costs of particular item or service or customer = Contribution Margin Per Unit
This process of calculating the contribution margin for each item and service will definitely help you to figure out which product or service is causing more profit to your company and which product or service is causing less profit to your company. Thus you can adjust the prices of that product and service in order to earn more profit for your company.
Whereas, the total contribution margin of the company gives you a clear picture of the performance of the company as a whole.
How To Calculate Contribution Margin As A Percentage Or Ratio
The Contribution Margin Ratio can be represented per unit and can also be represented as a whole
Mathematically the Contribution Margin Ratio as a whole can be represented as,
Total Contribution Margin Ratio = Total Contribution Margin / Total Sales
Contribution Margin Ratio per unit = Contribution Margin per unit / Sales per unit
The Contribution Margin Ratio or percentage can be used to find out how the contribution margin is affecting your net income.
Points To Remember While Calculating Contribution Margin
Let us have a look at some of the points that should be kept in mind while Calculating Contribution Margin
- While calculating Contribution Margin you must subtract the variable cost carefully from the revenue and sales. You have to Define variable costs wisely.
- You must use the above-mentioned formula in order to include gross profit math and thus you will be able to see both contribution margin and gross profit.
- The contribution margin and operating margin both are different from each other. The amount of revenue left after subtracting the variable costs is referred to as the operating margin. Mathematically it can be represented as,
Operating income / Net sales = Operating margin
- The contribution margin income statement will show the same amount for net income as your regular income statement. You should not use the Contribution Margin income statement for external use.
Advantages Of Calculating CM (Contribution Margin)
Let us have a look at some of the advantages of calculating Contribution Margin
- You will be able to set the prices of the products based on the data collected.
- It will be easy for you to set profit and goal-oriented pricing
- You will be able to optimize the prices of the products.
- You will be able to optimize the structure of the sales commission.
- You will be able to Use Management Accounting in order to increase the profitability goals of the company.
- You will be able to get clear data on each product and service.
How To Calculate Contribution Margin Perfectly
If you want to calculate the contribution margin perfectly, then you have to define your variable costs and fixed costs effectively. For gross profit, it should be calculated as direct variable expenses and for contribution margin, it should be calculated as indirect variable expenses. You must make sure that no expenses are recorded in the wrong category on your income statement or else you will make wrong decisions based on inaccurate data.
You must clearly know about the fixed and variable costs of your company to calculate the Contribution Margin and Gross Profit accurately to increase the profitability of your company.
In the End
We hope that now you completely know about Contribution Margin and Gross Profit and would be able to calculate Break Even easily by yourself. Just follow all the points carefully, the guidance provided in this article will definitely help you to know about Contribution Margin and Gross Profit in a hassle-free method. We recommend you read the entire article and follow all the points without skipping a single point.
Q. Is the contribution margin always higher than the gross margin?
Yes, If you calculate gross margin and contribution margin then your company’s contribution margin should always be higher in comparison to its gross margin. Because if you calculate gross margin then it includes fixed overhead costs while contribution margin excludes fixed costs.
Q. How good is a high contribution margin?
If you calculate the contribution margin then it is better if it is closer to 100%. A higher ratio indicates that your company covers its fixed costs by generating more money.
Q. How can a company increase its contribution margin?
If your organization should increase its operational efficiencies then your contribution margin can increase automatically. For example: If you increase your product price or optimize the efficiency of your machine to reduce the cost and produce the same number of products in less cost as well as in less time.