Welcome aboard this journey into two fundamental economic concepts that everyone working on projects should know: gross margin and contribution margin. Don’t worry, we won’t get lost in boring technicalities; we’ll explain everything with practical, simple examples to help you better manage your projects and business. Ready to turn these numbers into winning allies?
Imagine you run a lively homemade lemonade business in a bustling tourist area. During the summer, you offer a range of delicious lemonades, from classic lemon to exotic flavors like blueberry and basil. Each glass of lemonade sells for €2, but thinking you make €2 per glass is a bit too optimistic! The cost of ingredients, containers, and production plays an important role.
Suppose the cost of direct materials (lemons, sugar, water, cups…) per glass of lemonade is €0.50. Your gross margin is calculated as the difference between the selling price and direct external costs:
So, for every glass of lemonade sold, excluding the direct costs of ingredients, you’re left with €1.50. But stopping here would be too simple! We also need to consider labor costs.
Here’s where contribution margin comes in, helping us better understand our business’s financial situation. Contribution margin goes beyond gross margin by including the costs of staff directly involved in making the lemonade.
Suppose labor costs per glass of lemonade are €0.30. So, the contribution margin calculation will be:
This €1.20 is what actually contributes to covering fixed costs, and if anything remains, that’s your profit.
Now, let’s apply this concept to a communication agency creating ad campaigns. The margin calculation process is similar but applied to services rather than products.
If a campaign is sold for €10,000 and direct costs (freelance designers, ad space purchases) are €6,000, your gross margin will be:
To calculate the contribution margin, we also need to include the labor cost of the team who worked on creating the campaign:
Knowing the gross and contribution margins helps make informed decisions about which products or services to keep, develop, or drop. A product with a low contribution margin might not be sustainable long-term, even if the gross margin looks positive. Moreover, it allows you to identify which aspects most impact a project’s profitability: external costs or internal costs. This information is essential for making well-informed strategic decisions.
These metrics are also crucial for break-even planning (the point where generated revenue is enough to cover costs) and for pricing strategy. When understood and monitored correctly, margins can guide business management toward greater efficiency and profit.
Gross margin and contribution margin are more than just calculations; they’re compass and radar, guiding your business through market challenges. Understanding and using these tools will allow you to improve project management, optimize costs, and maximize profits. Don’t overlook the importance of these metrics: integrate them into your business strategy, and you’ll see the results.
If these calculations gave you a headache, don’t worry, we’ve got the solution: wethod. Our app automatically performs all necessary calculations, allowing you to get precise, detailed reports without any effort. Like a trusted co-pilot, wethod supports you in managing costs, providing a clear and detailed view of your financial situation, project by project. Request a demo today and be amazed at how easily you can navigate the numbers!
*Disclaimer: in economics, the costs impacting contribution margin are not limited to personnel but include all variable costs directly attributable to production. In this article, however, we simplified the explanation by focusing on a context similar to that of service-oriented companies.
