Decoding Profit Margins: Gross, Net, Operating, Contribution and Pocket Margins. Differences, use cases and formulas

Understanding the Different Types of Profit Margins

Pyramid of Profitability Indicators

Open any financial report and you’ll notice different terms applied to company’s profitability. Most likely, you’ll see Gross Margin, Operating Margin and Net Margin. In the real day-to-day operations you might also encounter terms like Contribution Margin and Pocket Margin. They all are important for understanding if the company is doing well in terms of making money on the goods or services it sells.

To simplify your understanding  of these various types, imagine an upside down pyramid.

Gross Margin:

This is the starting point. It is calculated by subtracting the Cost of Goods Sold (COGS) from Revenue. Gross margin shows how efficiently a company uses labor and supplies in producing goods or services.

Calculation: Gross Margin = (Revenue - COGS)/Revenue × 100

Operating Margin:

This comes next. After calculating the gross margin, when you subtract other operating expenses (like salaries, rent, utilities, etc.) but not interest or taxes, you get the operating margin. It reflects the efficiency of a company's core business operations.

Calculation: Operating Margin = Operating Income (EBIT)/Revenue × 100

Pocket Margin:

This is a more detailed analysis. Pocket margin goes further by deducting additional expenses like marketing, distribution, discounts, and allowances from the operating income. It provides a more comprehensive view of the actual profitability of specific products or services. This type of margin is particularly important for pricing managers, category managers and revenue managers as it shows true efficiency of the company’s coordinated efforts: marketing, sales, product, growth, etc.

Calculation: Pocket Margin = (Revenue - COGS - Operating Expenses - Additional Costs)/Revenue × 100

Net Margin:

This is the final level. After subtracting all expenses, including interest and taxes, from the operating income, you get the net margin. It shows the overall profitability of a company. This type of profit margin would be more relevant to financial department when they publish a report for investors or the public

Calculation: Net Margin = Net Income/Revenue × 100

What About Contribution Margin?

Contribution Margin:

The Contribution margin doesn't actually fit into this sequence linearly. Instead, it's a separate analysis that looks at the profitability of individual items or segments. It is calculated by subtracting variable costs (but not fixed costs) from revenue. It helps in understanding how much a particular product contributes towards covering fixed costs and generating profit. Again, this metric would be important for category managers, data analysts and eCommerce managers to see what categories and products perform better than other to make efficient assortment decisions.

Calculation: Contribution Margin = (Revenue - Variable Costs)/Revenue × 100

But what kind of profit margin can you see in Aimondo's dashboard Margin report? Actually, it can be any kind of the above mentioned margins. If you use Aimondo without any integration, as a data provider (one-way flow) we obviously can't calculate your Pocket or Contribution margin — we just don't have data for this. You will only see an increase potential. ‍

However, if you have an integration in place you will be receiving reports on the profit margin types that are most relevant to your role or task at hand (assortment analysis, pricing and promotions analysis, etc.)

Making Strategic Decisions Based on Profit Margins

Pricing and Cost Management‍

Understanding different profit margins is integral to developing a robust pricing strategy. By analysing Gross and Net margins, businesses can determine the minimum price points needed to cover costs and ensure profitability.

Analysing Pocket margin pricing managers can determine the efficiency of company’s marketing efforts: does it make sense to offer an 80% discount? Or the increased number of sales does not  balance the decrease of profitability? Was this particular email marketing campaign “Buy 2 get 1 for free” efficient? Meaning, did it help company generate profit? Or was it just a waste of resources? ‍

Product Line Decisions‍

As mentioned above, Contribution margin would help pick top performing products in the product list and get rid of the “weak links” that drag company’s profitability down. A high Contribution margin indicates that a product is not only covering its variable costs but also significantly contributing to covering fixed costs and generating profits. This insight is vital for decisions regarding which products and categories to prioritise or expand. ‍

Investment and Expansion‍

Profit margins are key indicators for strategic decisions regarding investment and business expansion. A strong Net margin suggests that the company has enough profitability to reinvest in its operations, which can be pivotal in decision-making for expansion. Businesses often use these margins to identify profitable product lines that warrant further investment. Additionally, analysing trends in Operating margin can signal the right time to scale operations or enter new markets.