How to calculate margins
/What is a Margin?
A margin is the difference between sales and expenses. There are a number of margins that can be calculated from the information located in the income statement, which give the user information about different aspects of an organization's operations. The contribution margin and gross margin examine different aspects of the amounts earned from the sale of products and services prior to selling and administrative expenses. The operating margin examines the operational results of an entire entity, while the profit margin is intended to reveal the total results of a business. The calculation of these margins is noted below.
Contribution Margin
The calculation for contribution margin is sales minus all totally variable expenses, divided by sales. Product variable costs typically include, at a minimum, the costs of direct materials and sales commissions. The calculation is as follows:
(Net product revenue - Product variable costs) ÷ Product revenue = Contribution margin
Under this approach, all fixed expenses are pushed further down the income statement, while sales commissions are shifted out of the sales department expenses and placed within the totally variable expense classification. This margin makes it easier to see the impact of variable expenses on a business and the amount of the contribution toward fixed expenses. For example, if sales are $100,000 and variable expenses are $80,000, then the contribution margin is $20,000, or 20%.
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Gross Margin
The calculation for gross margin is sales minus the cost of goods sold, divided by sales. It differs from the contribution margin in that the gross margin also includes fixed overhead costs. Because of the presence of some fixed costs, this percentage can vary somewhat as sales levels change, making it more difficult to ascertain the real product margins of a business. For example, if sales are $100,000 and the cost of goods sold is $60,000, then the gross margin is $40,000, or 40%.
Operating Margin
The calculation for operating margin is sales minus the cost of goods sold and operating expenses, divided by sales. This margin is useful for determining the results of a business before financing costs and income taxes. Thus, it focuses on the "real" results of a business. For example, if sales are $100,000, the cost of goods sold is $60,000, and operating expenses are $25,000, then the operating margin is $15,000, or 15%.
Profit Margin
The calculation for profit margin is sales minus all expenses, divided by sales. This is the most comprehensive of all margin formulas, and so is the most closely watched by outside observers to judge the performance of a business. For example, if sales are $100,000, the cost of goods sold is $60,000, operating expenses are $25,000, and financing costs and income taxes are $12,000, then the profit margin is $3,000, or 3%.
How to Analyze Margins
These margins should be tracked on a trend line. By doing so, you can readily spot spikes and drops in the margins earned by a business, and investigate the reasons why these changes occurred. It is also useful to compare these margins to the same calculations for competitors. Such investigations are a key management technique for maintaining reasonable margins in a business.