The profitability of a company is often described as its net profit, or in everyday terms, the bottom line. While this is the ultimate yardstick for a company’s success, it is important to also consider some other measures of profitability when analyzing a firm's financial standing. Gross margin and contribution margin are two values that can provide helpful insights when performing financial analysis on a company.
What is Gross Margin?
Financial analysts often analyze data by making each line item of the income statement a percentage of net sales. Gross margin is the term used by accountants and financial analysts for gross profit as a percentage of net sales. Gross profit and gross margin are helpful indicators in calculating the profitability of a company's operations, as it is calculated by subtracting the cost of goods sold from sales revenue. The cost of goods sold includes both variable and fixed costs associated with the production processes of the company. Gross margin is calculated by dividing the gross profit by the net sales figure.
What is Contribution Margin?
Contribution margin is simply described as the amount of money left after covering the firm's variable expenses. Variable expenses are those that vary according to the company's production levels and include items such as raw materials and direct labor. Notably, contribution margin is separate from gross margin, as it does not include any fixed costs in its calculation. Contribution margin is calculated by subtracting variable costs from the firm's sales.
The Importance of Gross Margin
Gross margin is an important measure to help companies determine their selling price and breakeven point. The breakeven point is the point where the company's revenues equal its expenses and is helpful to determine the selling point of the items that the company sells. Additionally, gross margin helps the company determine if the components of its cost of goods sold are too high.
The Importance of Contribution Margin
Contribution margin is important in determining a company's breakeven point. The firm can determine its breakeven point by calculating the contribution margin per unit by subtracting the per-unit variable costs from the per-unit sales. After the contribution margin per unit is calculated, the breakeven point is determined by dividing the fixed expenses for the period by the contribution margin per unit.
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