Utilize Key Financial Drivers to Help Measure Your Business
Originally published on February 15, 2016
Updated on November 1st, 2023
Many business owners overlook the key financial metrics that should be utilized to measure and manage growth within their company. These owners often fail to realize that running a business without considering key financial drivers is like trying to navigate to an unknown destination without a map. If you’re unsure how to manage your business “by the numbers” and don’t where to begin, start with analyzing and utilizing your company’s Gross Margin and Contribution Margin. These two drivers relate to the Income Statement (or Profit and Loss Statement) and offer valuable information about the earning power or profitability and cost structure of your business.
Gross Margin is calculated by dividing Gross Profit by Sales. Gross Profit is calculated by subtracting Sales from the Cost of Sales, which is the cost of buying raw materials and producing finished products. Gross Profit measures what remains after direct expenses, such as direct labor and materials, which must be subtracted from revenue.
GROSS MARGIN = GROSS PROFIT/SALES
So how do you use the Gross Margin ratio within your business? As an example, a Gross Margin of 47.7% means that for every $1 of Sales, the business produces 47.7 cents of Gross Profit. This means that the business has 47.7 cents to use for other operating business expenses. This key piece of information will help you determine if the pricing structure of your product or service is appropriate, and if you can generate enough revenue to produce a positive Gross Margin and cover your business’s other operating expenses.
If you’re an early revenue or start-up company trying to manage expenses, you will want to focus on Income Statement management and knowing your cost structure. This information can be used to determine what pricing is needed to cover costs and will help you better understand the key drivers of costs and which costs can be reduced or eliminated. Contribution Margin will tell you the amount of money from sales left after variable costs are paid. In other words, Contribution Margin is the amount left to contribute to covering the business’s fixed costs and if any will be left over for profits.
Contribution Margin is calculated in three steps:
1. First, total the entire business’s Variable Costs (those that vary directly or proportionally to sales). You can identify these costs by asking yourself: Does sales cause this cost? If the answer is yes, then it is a variable cost. Examples are: Direct Labor, Direct Materials, Commissions, Bad Debt, and Other Sales and Marketing related costs.
2. Second, divide total Variable Costs by Sales to calculate the Variable Cost Percentage.
VARIABLE COSTS/SALES =VARIABLE COST
3. Lastly, subtract the Variable Cost Percentage from 100% (the Sales %) to calculate the Contribution Margin Percentage. This will be the amount that is left to fund fixed costs and profits from every $1 of sales.
CONTRIBUTION MARGIN % = SALES % – VARIABLE COST %
Which is the same as:
CONTRIBUTION MARGIN % = 100% – VARIABLE COST %
The higher the Contribution Margin the more profitable the business is on a unit basis. This is important to know when making decisions on whether the business can afford to spend money on sales and marketing to acquire new customers and fuel growth or whether a price increase is needed just to cover fixed costs and make a profit.
Running a business a hard, and making a profit is even harder. If you haven’t done so already, consider utilizing key financial drivers to help improve your fiscal management and make smart decisions about your company’s growth, product pricing, expenditures and much more.
All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.
Other Posts You Might Like