In business, the contribution margin is essentially the dollar contribution per unit of whatever it is that’s being made, sold, or offered. For example, an individual widget – one of a thousand, say – would have a contribution margin that reflects its selling price minus its variable cost. The widget’s “contribution” to the manufacturer’s revenue earned is that portion of sales revenue not eaten up by the maker’s variable costs, with the contribution able to go towards the maker’s fixed costs, for one.
Of course, in business you need to be able to properly account for your contribution revenues, or income, for a variety of reasons. And the way to go about doing so is through use of what’s called a contribution margin income statement. Such an income statement is always a part of basic finance and accounting, in fact, as you can see from this Udemy course on basic financial accounting.
Contribution Margin and the Income Statement
There are a couple of different versions of the standard income statement found in accounting and finance, though all income statements are broadly considered profit and loss (P&L) statements. A contribution margin income statement simply deducts an array of variable costs from sales of a unit of something made or produced or offered to determine the amount, or margin, of the unit’s contribution to all revenue or income earned by a company.
Once you’ve determined a unit’s contribution margin all you need do is subtract applicable fixed costs, or expenses, to determine your net profit or net loss for a given period. A small percentage of your company’s fixed costs can be allocated or assigned to each unit your business produces, though such an activity is more complex in actual business.
“Fixed costs” are the kinds of expenses in your business that never go away, and they include costs such as rental of your facilities, which must be paid even if you make no widgets or units that month. Of course, you facility rent won’t rise if you make tons of something the next month, which is why rent is a fixed cost. Lease payments for office and manufacturing equipment – and in business it often makes sense to lease rather than buy equipment – are another example of fixed costs. The Udemy.com education website provides introductory financial accounting training that can help you understand contribution margin, fixed costs and financial statements.
Variable costs, by contrast, change all the time, which is why they’re “variable.” Most variable costs in business fluctuate based on the company’s activity levels, such as added production runs or additional utility and energy needs. If you produce 50,000 units one month but double that to 100,000 units or widgets or whatever the following month you’ll use more energy resources, capital and so forth, thus increasing your variable costs.
At base, a contribution margin income statement seeks to explicate or easily illustrate or explain and even separate your variable costs from your fixed costs. This sort of income statement serves a wide variety of purposes in accounting, business and finance. For one keeping an eye on your contribution margins per unit of something allows you to identify positive and negative expense and revenue trends. If you’re dedicating too much capital or resources, say, to a particular widget, its contribution to revenue will decline and, on an economy of scale, so will your total revenue.
However, if you’ve really hit on a winning production formula for your world-beating widget, pushing variable costs ever lower yet delivering a superior and very popular product, its contribution margin should be positive and revenue-increasing. The better your unit’s contribution margin the better overall it is for your business, in other words.
Managers in any business need a basic financial accounting foundation in order to maximize productivity while keeping fixed and variable costs in line, something an understanding of contribution margin assist in. Udemy.com discusses such accounting skills for managers that can be highly beneficial for those in need of a broader understanding of the subject.
How a Contribution Margin Income Statement Varies From a Standard Income Statement
While all income statements are basically P&L statements there are differences between a contribution margin income statement and a standard P&L or income statement found in most general accounting activities. For one, contribution margin statements display aggregated, or collective, fixed costs lower down in the statement, where they’re found after the contribution margin itself is actually stated.
Another way in which contribution margin income statements differ from standard P&L statements is in how variable selling and administrative expenses or costs are grouped with variable production costs. Contribution margin statements always group variable and administrative expenses with variable production costs, something not done on a standard income statement.
Lastly, standard income statements display a gross margin or the difference between revenue and cost, but before accounting for a number of other costs. A contribution margin income statement, by comparison, displays the contribution margin, of course. In a way, contribution margin also provides more detail when it comes to the resources and expenditures needed to produce a unit of something.
Layout of the Contribution Margin Income Statement
Simply laid out, this is the format needed to develop a contribution margin income statement:
- +(add) Sales
- -(subtract) Variable costs of production (e.g. materials, supplies, your variable overhead)
- – (subtract) Your variable selling expenses as well as your variable administrative expenses
- =(equals) The contribution margin per unit of something
- -(subtract) Your fixed production costs or expenses, including most of your overhead
- -(subtract) Your fixed costs of selling as well as your fixed administrative expenses
- =(equals) Your net profit or loss
While there are key differences between a contribution margin P&L statement and a standard P&L or income statement, the resulting net profit or loss will still be the same under every circumstance. If you find a net profit or loss that differs between your contribution margin income statement and your company’s standard income statement you’ve incorrectly added or subtracted your fixed or variable costs, or both of them.
Fortunately, generally accepted accounting principles, or GAAP, and the manner in which business accounting is conducted supply plenty of directions when it comes to correctly designating and then allocating your fixed and variable costs or expenses. Of course, you’ll need to spend some time in learning GAAP and just how accounting works, but once you do you should have little trouble in determining an accurate contribution margin per unit of whatever it is your business makes. Udemy.com itself shows business managers and entrepreneurs just how to go about creating financial statements, including for contribution margin.
Contribution Margin and the Breakeven Point
No business ever makes a unit of something without examining the contribution margin so that it can determine what’s called the “breakeven point,” or the number of units it must sell to at least break even and not take a loss. A “contribution margin ratio” plays a large role in determining breakeven. Here’s a very simple example of the formula to determine the breakeven point of a widget:
The breakeven point in units = (equals) fixed expenses/ (divided by) unit price – (minus) variable expenses. Here’s a simple example:
Breakeven point = $80,000/$3.00 – .90 = 26,666 units.
You can develop your company’s contribution margin income statement by converting the breakeven number of units – in this example, 26,666 – to a breakeven in dollars. Your variable expenses of $0.90 per unit amount to 33.33% ($0.90/$3.00) of sales of $3.00 for each of your units sold. Your break-even point in dollars, then, is reached by dividing your unit’s fixed expenses by the contribution ratio, which is arrived at by dividing your unit’s fixed expenses of $80,000 by .6667 (100 – 33.33, or your variable expenses, = 66.67) or $119,994.
Based on the fixed expenses to produce your widget and your contribution margin ratio, your company is going to need to make about $120,000 in sales of the widget, by selling nearly 27,000 individual units, in order to break-even on its production.
In this example, fixed expenses may be eating up a large portion of all expenses in order to get your widget produced, and a contribution margin income statement could assist you in identifying possible areas for additional cost savings. Understanding breakeven point is crucial in product management, and Udemy.com offers training in just how breakeven point and product management basically go hand-in-hand together.
Contribution Margin, Business Decisions and Your Company’s Finances
It’s certainly possible to run your business on instinct and gut feelings, but it’s usually always better to become adept at analysis coupled with instinct. For example, by analyzing your contribution margins you can often become better informed before making a business decision related to production or sale of your company’s widgets. Suppose you have several product lines, each producing a different product or widget, with an attached contribution margin income statement for each.
Analyzing your contribution margins by comparing the profitability of each product offered may assist you in deciding just which products should receive priority in resources and investment, for instance. If you have two strongly profitable widget production lines and one that’s weaker, either breaking even or just barely profitable, you may decide to end its production or at least shift available extra resources to your other two lines, which is yet another reason why contribution margin and the income statement is so useful in business and finance.
By making sound business decisions – proceeding from instinct, of course, but instinct and experience that’s backed by sound analysis – you and your company are able to intelligently and rapidly allocate resources as well as expenses when and where they’re needed most.
In some regards, it’s helpful to look at something like a contribution margin income statement as a crystal ball because, though it’s providing a retrospective look only, it can help you formulate plans for future production or business decisions, quickly cutting off resources and investment to losing production lines. If you really want to improve your managerial and financial accounting abilities, definitely make use of this Udemy.com introduction to financial accounting course.