One of the processes that any business must go through is the preparation of an income statement. This is especially true if the company is publicly owned, though privately-owned companies must still prepare one. Typically, “cost of sales” refers to all costs associated with the production of goods or the delivery of services. The remaining expenses will be either operating or non-operating. However, did you know that there is another type of income statement that does not adhere to the standard profit-loss structure?
Instead of categorizing expenses as “cost of sales” and “operating and non-operating expenses,” this income statement categorizes them as “variable costs” and “fixed costs.” This income statement is known as the Contribution Margin Income Statement or simply the Contribution Income Statement. In this article, we’ll look at what a contribution margin income statement is, the format, and how it can help your business.
What is Contribution Margin Income Statement?
A contribution margin income statement refers to an income statement that is used to calculate the company’s contribution margin. The contribution margin is derived by subtracting the variable expenses incurred by the company for the period from the total sales of the company, and when the fixed expenses are subtracted from the contribution margin, the resultant figure is the company’s operating income.
Components of Contribution Margin Income Statement
The following are the various components that are commonly found in the Contribution margin income statement:
#1. Revenue:
Revenue is the total sales made by the company during the period through the sale of goods or the provision of services to the company’s customers. It is determined by multiplying the number of units sold by the per-unit cost of the goods sold.
#2. Variable Cost
Variable cost refers to all costs incurred by the company that change with the change in the level of output of the company, i.e., it increases with an increase in output and decreases with a decrease in output.
#3. Contribution Margin:
The contribution margin is calculated by deducting the company’s total variable cost during the period from the total sales made during the period.
#4. Fixed Costs
Fixed cost refers to all costs incurred by the company that does not change with the company’s level of output, i.e., they remain constant regardless of the company’s level of output.
#5. Income
Income is calculated by deducting the total value of the company’s fixed costs during the period from the Contribution Margin.
How to Calculate Your Contribution Margin
The contribution margin is calculated as the first step in creating your contribution margin income statement. So, you’ll need your sales revenue and variable cost information for this. Variable costs will include any variable administrative costs as well as any variable production costs. Your contribution margin is calculated as follows:
Product Revenue = Net Product Revenue (Sales) – Total Variable Costs
If your product revenue is $500,000 and your total variable expenses are $250,000, your contribution margin is $250,000 $500,000, or 50%.
How to Determine Your Contribution Margin Income
To calculate your contribution margin income, add your total fixed production expenses (production expenses, fixed administrative expenses, and sales expenses) to the contribution margin. The formula is as follows:
Net Profit or Loss = Contribution Margin – Total Fixed Production Expenses
If your total fixed production expenses were $300,000, your net profit would be ($50,000) ($250,000-$300,000). Because this is a loss, you must determine how to compensate for the -$50,000 by increasing sales or decreasing fixed costs.
So, to break even, you’d need to cut costs by $50,000. Divide the loss by the contribution margin to determine how much to increase sales.
$50,000 * 50% = $100,000.
To break even, you’d need $100,000 more in sales.
What Is the Difference Between a Contribution Margin Income Statement and a Standard Income Statement?
In three ways, a contribution margin income statement differs from a standard income statement. Firstly, after the contribution margin, fixed production costs are aggregated lower in the income statement. Second, variable selling and administrative expenses are combined with variable production costs to calculate the contribution margin. Finally, the contribution margin replaces the gross margin in the statement.
The Contribution Margin Income Statement Format
The following is the format of a contribution margin income statement:
| + | Sales |
| – | Variable production expenses (such as materials, supplies, and variable overhead) |
| – | Variable selling and administrative expenses |
| = | Contribution margin |
| – | Fixed production expenses (including most overhead) |
| – | Fixed selling and administrative expenses |
| = | Net profit or loss |
Net Profit or Loss
In many cases, direct labor is classified as a fixed expense rather than a variable expense in the contribution margin income statement format, because this cost does not always vary in direct proportion to the amount of revenue generated. Instead, management must maintain a certain minimum level of staffing in the production area, which does not change with lower production volumes.
The primary distinction between gross margin and contribution margin is that fixed production costs are included in the cost of goods sold when calculating the gross margin, but not when calculating the contribution margin. This means that the contribution margin income statement is sorted by the variability of the underlying cost information rather than the functional areas or expense categories found in a traditional income statement.
The net profit or loss will be the same under both the contribution margin income statement and a normal income statement because all revenue and expense items are included in both formats; only the order of presentation differs.
When you want to determine the proportion of expenses that truly varies directly with revenues, it is useful to create an income statement in the contribution margin format. Because a large portion of a company’s production costs are fixed and few of its selling and administrative expenses are variable, the contribution margin will be significantly higher than the gross margin in many cases.
Contribution Margin Income Statement Example
For example, suppose a company A ltd manufactures and sells various products on the market. The company’s total sales for the fiscal year 2019 were $ 1,200,000, direct material costs were $ 300,000, and direct labor costs were $200,000. During the same time period, the company paid $120,000 in rent and $60,000 in insurance expenses. Using the contribution margin income statement, compute the company’s contribution margin and income for the period.
Solution:
Calculation of the Contribution Margin and the Company’s Income
Income statement for the contribution margin:
As a result, the Contribution Margin for the period is $700,000, and the company’s Income for the period is $520,000.
The Advantages of Creating a Contribution Margin Income Statement
While you are not required to prepare a contribution margin income statement, doing so is still beneficial to your business.
Here are some of the advantages of using a contribution income statement:
#1. Improved performance analysis of a product or segment
Because expenses are classified as variable or fixed, it is much easier to determine whether a product, service or even segment is profitable or not.
#2. The contribution margin can be calculated by separating variable costs from total expenses.
The contribution margin can then be used to determine how well a particular product or segment is performing.
For example, suppose a company has two products: product A and product B.
- Product A has a unit price of $200 and a variable cost of $160.
- Product B has a unit price of $80 and a variable cost of $40.
So, assuming that both products sold the same number of units, which product contributes more to the business’s operations?
At first glance, it appears to be product A due to its high sales price of $200 per unit, which is significantly higher than product B’s $40 per unit ($200 – $160).
However, this is not always the case.
To get our answer, we must calculate each product’s contribution margin (sales price – variable costs).
Product A contributes $40 per unit ($80 – $40), whereas Product B also contributes $40 per unit.
In reality, both products contribute the same amount to the company’s operations (on a per unit basis)
#3. It aids in determining which variable costs consume an excessive amount of revenue.
Variable expenses are the easier to control of the two types of expenses (variable and fixed).
As a result, if a company wants to cut costs in order to increase profits, it will usually look into the variable costs that can be cut.
Because a contribution margin income statement categorizes expenses based on whether they are variable or fixed, determining which variable expenses can be reduced is much easier.
It is also easier to identify which expenses consume the majority of the revenue.
With this information, the company can plan what to do with the expenses.
For example, if a particular raw material consumes the majority of the finished product’s sales price, the company may decide to switch to a cheaper raw material or find a supplier who can offer the same raw material at a much lower price.
#4. Can be used to calculate break-even analysis.
The point at which revenue and expenses are equal is known as the break-even point.
Because a business has both variable and fixed expenses, the break-even point cannot be zero.
That is, it must generate a certain amount of revenue in order to cover its expenses.
It cannot be zero because it has fixed expenses that are incurred whether or not a business makes a sale.
The break-even point can be calculated using the following formula:
Break-even Point (Units) = Fixed Cost / (Sales Price per Unit – Variable Cost per Unit)
-or-
Break-even Points (Units) = Contribution Margin per Unit x Fixed Cost
As the formula above shows, calculating the break-even point requires the contribution margin, which is provided by a contribution margin income statement.
As a result, a contribution margin statement is far better suited for break-even analysis than a traditional income statement.
#5. It is easier to comprehend the impact of changes in activity level.
So, a contribution margin income statement presents its data in a way that makes it easier to understand the effects of changes in activity levels.
This is due to the fact that it displays the contribution margin, which is directly influenced by the level of sales.
Traditional Income Statement vs. Contribution Margin Income Statement
- It replaces gross margin.
- After the contribution margin, fixed expenses are cached lower.
- Variable expenses are factored into the contribution margin calculation.
Advantages
- Data is organized in a way that allows management to understand how changes in production and sales volumes affect profit.
- It aids in identifying variable expenses that consume an excessive amount of revenue.
- Despite the fact that the numbers remain the same, it provides a different perspective on the current financial situation.
- As fixed and variable expenses are separated, a better analysis can be performed.
- It can be used to calculate break-even points.
Limitations / Disadvantages
- Because the format is not recognized by GAAP, it cannot be shared with external users of financial statements.
- It only looks at the expenses.
- Only the internal audience has access to the income statement.
Conclusion
The contribution margin income statement is a format of the income statement that focuses on expenses that are divided for clarity. When looking at this statement, it is clear which business activity is generating revenue.
Contribution Income Statement FAQs
What does the contribution income statement highlight?
The statement highlights the contribution margin, which is the difference between sales and variable costs. The traditional format places a premium on the concept of gross margin, which is defined as the difference between sales and the cost of goods sold.
What is the objective of calculating contribution?
It’s a metric that’s rarely shared publicly and is instead used by managers and executives to make decisions. The contribution margin’s overarching goal is to assist these key players in improving the production process by analyzing their variable costs and (hopefully) finding ways to reduce them.
What does contribution mean in accounting?
Contribution is the amount of earnings left over after deducting all direct costs from revenue. This amount is available to pay for any fixed costs incurred by a business during a reporting period. Any contribution surplus over fixed costs equals profit.
