Almost every business owner has answered the common sense question, “What business?” from a friend or acquaintance. It’s a simple question, but small business owners know how complicated the answer can be.
While no number can fully summarize the state of your business, several metrics can help you gauge its health and identify ways to increase profitability. Among these are contribution margin and margin ratio, two ratios that measure value in different but important ways.
What is the Contribution Margin?
The contribution Margin measures how much money your company keeps after paying for the changes in your product’s production. While it can be used as a measure of your company’s profitability, it can be more useful in a linear fashion to measure the value of any product or service you sell.
Because the margin of engagement measures how much money you retain in the market for a given product after deducting variable expenses, such as sales and marketing activities, it will be clear that you will A tough product decision of which ones to invest more in and which ones to leave behind. . If the sales of the product are not enough to cover the cost of producing the product, this can be a big problem.
The formula for calculating the contribution margin is:
(net sales – variable cost to produce the product) / net sales x 100 = contribution margin
Here’s what the formula would look like using sales at zero cost: ($20 net sales – $10 variable cost) / $20 net sales x 100 = 50% contribution
The higher the variable cost ratio, the more money you have to pay business expenses, including fixed costs such as rent and equipment. So of course the percentage will be as close to 100% as possible, but probably lower than that in most cases. The appropriate ratio varies by company, but most companies operate with a contribution ratio below 50%.
What is the gross margin?
Gross margin, or gross profit margin, is the amount you have left after considering all of the direct costs of producing your goods and services, such as equipment and labor directly related to the production or distribution of these items. It is an important part of your business, and it gives you a comprehensive view of the company’s value and its potential for improvement.
In other words, profit margin can help your business monitor profitability over time because it takes into account changes in costs that are directly attributable to production. : you compare the sales you have made with the cost of labor, materials and any other costs. Pay immediately at the specified time. So, if your business isn’t capturing enough profit, profit margins can reflect significant changes in manufacturing costs or pricing models.
Generally, the ratio is expressed as a percentage. A margin of, say, 37% means your business keeps 37¢ for every dollar of revenue.
The general rules are:
[(total revenue – cost of sales) / total revenue] x 100 = gross margin
As shown, the ratio is a ratio that includes two accounting systems. The first is gross profit, or net sales, which is your gross profit minus returns or discounts on your products. The second is cost of goods sold (COGS), which is the direct cost of production, including materials and labor. Both measures are found in the company’s financial statements, which detail the company’s net income over a certain reporting period, usually a quarter or a year.
Here’s an illustrative example: A potter sells $6,000 in the first unit, and it costs $2,000 to produce the items.
The formula would look like this: [(total revenue of $6,000 – COGS of $2,000) / total revenue of $6,000] = 0.66 x 100. This shows that the margin is 66%.
Similarities and differences
Contribution margin and gross margin are ratios that provide insight into a company’s profitability, but they take into account different types of expenses and are often used to inform different types of business decisions.
- What they look like: Each is an indicator of value. Contribution margin and margin ratio measure expenses and sales.
- How they differ: Contribution margin measures the variable cost of producing a product or service, such as a sales commission, and tells the business owner how much money is left to spend on operating expenses. job. It focuses on a particular industry and can help a business owner decide which product lines to include and which to cut. Margins represent all the costs associated with producing and distributing what a business sells, giving a general idea of the potential value of the current price situation. It can also cause changes in demand, such as stock prices.