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How to Understand Contribution Margin and Gross Profit Margin

When companies want to increase profits, it's best to study the contribution margin and the gross profit margin. This is how unit economics is revealed. Unit economics reveals the relationship between the cost to generate revenue and revenue itself. Once you know the unit economics, you can then increase profits. It reveals which industries deliver the most profits, which marketing campaigns delivered the most profits and which sales people deliver the most profits. Unit economics gives companies full visibility into what specifically is making the profits. This way, decisions can be made to increase profits.

Without a doubt, it is important for companies to know and understand its contribution margin and gross profit margin. This knowledge sets the groundwork to increase profits.

Contribution Margin and Gross Profit Margin

Contribution margin is the money's left over after both indirect and direct costs. A good example of this is sales commission. There would be no commission if the job wasn't sold. This is considered indirect variable cost. Gross profit margin is the amount of money left over after the revenue is earned. It also includes subtracting the cost of goods sold. This can be seen in both dollars and percentage.

Contribution margins are percentages or ratios and reveal critical information, such as commission, pricing and the structure of sales. Both contribution margin and gross private margin allow companies to make data specific decisions to increase their profits. This is done by optimizing services, analyzing products, adjusting jobs and adjusting the employee incentive structure.

Determining the Gross Profit Margin and Contribution Margin

To find out the contribution margin, the variable costs are subtracted from the revenue earned from the sales of products or services. This process can be adjusted to reflect specific components. This way, an overall picture can be determined in ratio or percentage. The gross profit margin is determined by dividing gross profit by total sales.

Both contribution margin and gross profit margin are useful management tools. However, they are not the same thing. The gross contribution margin analyzes variable costs, while the gross profit margin is sales less the cost of goods. For example, if you sell handmade wreaths for $60 a piece and the variable cost to craft those wreaths is $30, the contribution margin is then $30. This is helpful when you're trying to decide which products are the most profitable. If some products aren't making enough profit, they can be eliminated. This can be done on all products. It looks at the company's performance as a whole. It also helps the company set goals.

Fixed overhead costs are never used when calculating the contribution margin.  The contribution margin is always higher than its counterpart. There are a number of factors that affect the gross margin. But, the main factors are sales earnings and merchandise costs.

Contribution margin is important to know for a company. It allows companies to know how much money they have for expenses like utilities and rent. The closer the contribution margin is to 100%, the better. Gross profit margin is important because it allows a company to know how to price their products or services. Prices can be adjusted to be increased if more profits are needed or the service or product can be completely eliminated.

The bottom line is that knowing the contribution margin and gross profit margin sets the framework to increase company revenue.

Request a demo below to see how AccountingDepartment.com's Accounting Specialists can assist you with you with calculating your Gross Profit Margin and Contribution Margin for your company, as well as many other financial data points.

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