How to Calculate Profit vs Contribution Margins

If you’re an early-stage entrepreneur, I bet your company’s financial health and efficiency are always at the front of your mind. After all, every decision you make, from pricing products to trimming expenses, directly impacts your future growth and profitability.

I also bet you’d like to feel more confident and at ease when making those decisions. To achieve this, understanding key financial metrics is essential for making smart, well-informed choices.

Profit margin and contribution margin calculations are two financial metrics that can make the difference between your company thriving or struggling to break even each month.

In this article, we’ll take a look at what profit margins and contribution margins are, how to calculate them, and why they’re crucial for your company. 

What are Profit Margins?

Profit margins are calculations that measure the percentage of revenue that remains as profit after accounting for expenses. 

A net profit margin of 15%, for instance, means that for every dollar you earn, 15 cents is kept as profit.

There are three types of profit margins, all of which give you different insights into the financial health, profitability and efficiency of your business. Therefore, all three are important to use and understand.

What is considered a “good” or “healthy” profit margin? This largely depends on which industry you’re in and the costs required to produce your products or services. 

In general, though, higher margins are better and indicate that your business is bringing in a high profit relative to your expenses. Lower profit margins, on the other hand, can be a sign that some improvements can be made.

Analyzing your margins can help you make decisions about where to cut costs or improve the efficiency of your operations. 

How Do You Calculate Profit Margins?

Gross Profit Margin

Gross profit margin measures how much revenue you retain after accounting for the cost of goods sold (COGS). It indicates how efficient your production is, and whether your overall pricing strategies are working.

Gross Profit Margin = ((Revenue – COGS) / Revenue) x 100

Operating Profit Margin

Operating profit margin reflects how much revenue remains after you pay your operating expenses, such as supplies, marketing, salaries and rent. Note that these expenses exclude taxes and interest. 

This indicates whether your company’s primary operational activities are being run efficiently and sustainably.

Operating Profit Margin = (Operating Income / Revenue) x 100

Net Profit Margin 

Net profit margin measures how profitable your business is after taking all expenses into account. Taxes and interest are included in this calculation. It indicates whether your company is effectively generating profit from its sales.

Net Profit Margin = (Net Income / Revenue) x 100

What are Contribution Margins?

A contribution margin evaluates the profitability of individual products or services. The selling price of each product plays a crucial role in determining this.

How much money is each product in your portfolio generating? How much does each unit sold impact your company’s overall profitability? 

Contribution margins can answer these questions and help you make smarter pricing decisions. 

They can also be used to conduct a break-even analysis, which helps you determine how many units you need to sell to cover your company’s costs and start turning a profit.

Variable Costs Versus Fixed Costs

Before you start calculating contribution margins, it’s important to know the difference between variable and fixed costs.

Variable costs are those that change according to the production volume. These include raw materials, per-unit shipping costs and hourly labor.

Fixed costs are those that don’t fluctuate with changes in production volume. These include office rent, machinery, insurance and salaried labor.

Since variable costs change depending on how many units you make and sell, they are used in contribution margins to offset unchanging fixed costs.

Accidentally including fixed costs in your calculations will give you an inaccurate representation of how many units you will need to sell to break even and start making a profit. This could lead to poor pricing strategies and unsustainable goals.

How Do You Calculate the Contribution Margin?

Contribution margin can be calculated through this simple formula:

Contribution Margin (in dollars) = Total Revenue – Variable Costs

This will show your contribution margin in dollars, that is, how much money your products generate to cover fixed costs and contribute to your profit numbers.

Contribution margins can also be expressed as a percentage by using this formula:

Contribution Margin (%) = (Contribution Margin / Total Revenue) x 100

Tips for Calculating Margins Accurately

Accurate margin calculations help you make effective decisions and smart pricing strategies. Any errors can directly impact your company’s profitability. 

Ensure your margins are accurate by doing the following:

Keep Your Financials Updated

Margin calculations, day-to-day accounting and taxes are much simpler if your finances are kept organized and up-to-date. Review your expenses, revenues and profits regularly, and make changes if needed.

Consider Seasonal Fluctuations

Many businesses operate with some degree of seasonality. If you run a retail business, for example, November and December are likely to be your busiest times, with profits dropping off once the new year hits. 

Take these fluctuations into account to ensure you’re making appropriate decisions for your business year-round.

Use Accounting Software

While margin calculations may seem fairly simple and straightforward, errors can be costly. Fortunately, affordable software like QuickBooks Online can help small businesses just like yours. It not only makes it easy to keep your finances organized daily, but it can also automate any calculations you may need to make.

Get Professional Accounting Help

As a busy startup or small business owner, you’ve got a lot on your plate. Sometimes, it doesn’t seem like there’s enough hours in the day to run your company, keep your finances up to date and analyze your margins.

Knowing when to get help from the professionals is vital for the financial health and long-term success of your business. 

At Finvisor, our team specializes in helping early-stage entrepreneurs with everything from accounting and bookkeeping to providing valuable support as your company grows.

With the help of an experienced accountant, you’ll know that your finances will be completed accurately and on time every single month.

Ready to work with us? Get in touch with Finvisor today to learn more about how we can help simplify your company’s finances.