Gross profit is an important indicator that helps with pricing and defining sales strategies. Learn how to calculate the contribution margin!
How do you manage your company’s finances? For it to be efficient, your team must know how to calculate the contribution margin. Also known as gross profit, this is one of the main metrics of any business. Therefore, it needs to be monitored correctly.
When you do this, you avoid common problems in the company. For example, the indicator may show possible financial difficulties, which affect the payment of bills . Therefore, monitoring it allows you to resolve difficulties and ensure the viability of the business.
It also allows you to find alternatives in case of other problems, such as a lack of working capital. This way, you can plan to avoid a significant impact on corporate finances.
Want to learn more about this topic? Check out this post to find out what contribution margin is and how to calculate gross profit!
What is contribution margin or gross profit?
The contribution margin represents the gross profit that the company obtained on the sales made. Therefore, it indicates the profit obtained after paying the product cost and taxes on products and services. In other words, the metric excludes variable expenses.
In all companies, gross profit is used to cover the fixed expenses of the business. Some of these expenses include payroll, rent, and equipment maintenance. In addition, this amount also constitutes the profit that will be distributed to partners and shareholders.
In practice, knowing what gross profit is is essential for smart management. This is because it shows the financial performance of the business. Therefore, you can find out whether the company’s revenue is sufficient to cover fixed costs and expenses and still record profits.
How important is this indicator in a company?
Having understood what the contribution margin is, it is time to understand the importance of this indicator. After all, if it is essential for efficient financial management, it is necessary to understand why.
In business routine, this metric is used in different situations, such as:
- assessment of the company’s profitability;
- definition of the minimum sales price;
- definition of the break-even point;
- development of sales strategies.
Therefore, calculating the contribution margin is essential for making sound management decisions. Based on the result, you can know whether products are being sold and expenses are effectively covered, for example.
Furthermore, the result indicates how much the profit from the sale of each product contributes to paying off the business’s fixed expenses. In other words, you find out whether the company is actually generating profit or whether adjustments need to be made to the processes.
Remember that financial management needs to be appropriate for the reality of the business budget, which is reflected in profit. Therefore, by observing the indicator, it is easier to ensure the survival of the business in the long term.
How to calculate the contribution margin?
Now that you have discovered why this indicator is important, you should know how the contribution margin calculation is done.
The formula is as follows:
Contribution margin = sales revenue – (variable costs + variable expenses)
To make this calculation, you must consider the sales value based on the final marketing price of the product . In turn, variable costs are those expenses related to production. Therefore, they vary according to the volume traded or manufactured.
Meanwhile, variable expenses change according to sales made. This is the case for sales commissions and taxes on products sold. It is also possible to calculate them individually for each product and service. In this case, you must add the results together to arrive at the total gross profit.
What is the ideal contribution margin for my business?
More than knowing how to calculate the contribution margin, you must understand how to interpret the result. In reality, the analysis depends on several factors, because its result will not be static.
In other words, gross profit varies according to:
- product;
- enterprise;
- time;
- competition;
- market.
And how do you determine the ideal contribution margin for your company? To answer this question, we suggest you think about the profit you want to make at the end of the month. This way, the reality of your business is taken into account in the analysis.
In addition, business sectors have average expected results, which can make their assessment viable. For retail companies, for example, the recommended contribution is between 15% and 20% for fixed expenses.
In turn, the average result in the industry is between 8% and 12%. Meanwhile, in the services sector, the trend is for the indicator to be between 20% and 30%.
In any case, these percentages are only indicative. This is because the company’s financial health may be fine, even with a margin smaller than these averages. In other words, each case needs to be analyzed individually.
How can contribution margin be improved?
With all the information you’ve seen so far, you may want to know how to improve your contribution margin. Achieving this goal depends on proper management.
Thus, the three main possibilities to achieve this purpose are:
- changing the prices of products and services : analyze the competition to see how the price charged in your company compares to other businesses. Another possibility is to do the inverse calculation of the contribution margin to find out the minimum selling price;
- reducing costs and variable expenses : this can be achieved through good practices. Some of these include negotiating with suppliers, improving tax planning and efficient financial management;
- reduction of fixed costs : this is the ideal alternative to alleviate the contribution margin target. To do this, it is necessary to consider savings on utility bills, outsourcing of activities and renegotiating debts.
Any of these possibilities can be implemented more easily with the help of financial management software. In this scenario, your company needs to have a strategic partner who can help you take better care of your corporate finances.