How to calculate margins

A margin is the difference between sales and costs. 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 as follows:

  • Contribution margin. The calculation is sales minus all totally variable expenses, divided by sales. Under this approach, all fixed costs 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 costs on a business and the amount of the contribution toward fixed expenses.
  • Gross margin. The calculation 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.
  • Operating margin. The calculation 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. Thus, it focuses on the "real" results of a business.
  • Profit margin. The calculation 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.

These margins should be tracked on a trend line. By doing so, one can readily spot spikes and drops in the margins earned by a business, and investigate the reasons why these changes occurred. Such investigations are a key management technique for maintaining reasonable margins in a business.