The contribution approach to the income statement emphasizes the distinction between ________.

As a business owner or manager, you need to know how much money your business is earning as well as how much money the business is spending.

You don’t want to just be earning money only for it to be eaten away by expenses incurred by the business or worse, if your expenses are exceeding your revenue.

The income statement is your friend when it comes to your business’s revenue and expenses.

Preparing an income statement is one of the processes that any business will have to go through.

This is especially true if the business is publicly owned, though privately-owned businesses would still have to prepare one.

Government agencies such as the SEC and the IRS require businesses to prepare and submit a copy of their income statements.

An income statement that is designed for external use will follow the GAAP or IFRS recommended format.

Typically, it groups all costs related to the production of products or delivery of service under “cost of sales”.

The rest of the expenses will either be operating or non-operating expenses.

However, did you know that there’s another type of income statement that doesn’t follow the usual profit-loss structure?

Instead of grouping expenses into “cost of sales” and “operating and non-operating expenses”, this income statement groups expenses into “variable costs” and “fixed costs”.

We call this income statement the Contribution Margin Income Statement or simply, Contribution Income Statement.

In this article, we will be exploring what a contribution margin income statement is, and how it could be used for your business.

We will also be learning how to prepare one so that you could use it for your business.

A contribution margin income statement is a special format income statement that categorizes expenses into variable and fixed costs.

It is used to provide a clearer picture of which costs change along with the level of activity (variable costs), as well as which ones don’t (fixed cost).

This is particularly useful when assessing whether a product, service, or segment is profitable.

Just like the traditional income statement (profit and loss statement), it starts with the business’s revenue.

What comes after is where it deviates. Instead of listing down the cost of sales, it instead lists all variable costs.

That includes production, selling, and administrative expenses as well as non-operating expenses so long as they are variable.

The difference between the revenue and the variable costs is the contribution margin (hence, the name “contribution margin income statement”).

After the contribution margin comes the fixed costs.

Same with variable costs, fixed costs include fixed production, selling, administrative, as well as non-operating expenses.

Subtracting the fixed costs from the contribution margin will give us the business’s net profit/income.

The contribution margin income statement helps plan for different levels of activity as it clearly shows the amount of fixed costs a business has to cover.

For example, if a business has $5,000 in fixed costs, then its contribution margin should be more than $5,000.

If its product is selling for $5 each and that its variable cost is at $3 per unit, then the business’s contribution margin is at $2 per unit.

For it to not incur a loss, it will have to sell at least 2,500 units.

Note that since the contribution margin income statement doesn’t follow the format prescribed by the GAAP and IFRS, it isn’t suitable for external use.

A business will still need to prepare a traditional income statement.

Variable and Fixed Costs

Variable costs, in the context of the contribution margin income statement, are expenses that increase or decrease along with the level of activity.

For example, raw materials cost increases the more products are manufactured.

Another example, there would be no cost of goods sold if there are no sales.

Basically, if the level of activity is zero, variable costs will also be zero.

However, since a zero activity level means no sales, there would be no revenue, and hence no contribution margin.

Fixed costs on other hand don’t increase or decrease with the level of activity.

Rather, they stay relatively the same whatever the level of activity is.

If they do increase or decrease, it’s usually not due to changes in the level of activity.

For example, rent for the building that houses production will remain the same whether a business produces 1 or 1,000 units of products.

However, there is one type of situation in which fixed costs can increase due to an increase in the level of activity.

This situation is called the “step cost situation” wherein a block of expenses must be incurred to accommodate an increase in the level of activity.

For example, if a production facility can no longer house additional production due to it already operating at maximum capacity, then the business will have to secure another production facility if it plans to produce more units.

Due to the acquisition of a new production facility, rent or depreciation expenses will increase.

In summary, variable costs go up and down depending on the level of activity, whereas fixed costs will remain the same unless there is a “step cost situation”.

This is important to note when planning for your business’s level of activity.

Contribution Margin Income Statement vs Traditional Income Statement

While both income statement formats list revenue as their first line item, what comes after is where they differ, particularly the categorization of expenses.

Under a traditional income statement, expenses are categorized under the cost of sales, operating expenses, and non-operating expenses.

A contribution margin income statement on the other hand categorizes expenses on whether they are variable or fixed.

The net income (before taxes) of both income statements would still be the same.

A prominent feature of the contribution margin income statement, the contribution margin, cannot be found in a traditional income statement.

A contribution margin can only be computed by subtracting the variable costs from the revenue.

Since a traditional income statement does not group variable expenses, it cannot show the contribution margin.

A contribution margin income statement emphasizes expenses (variable and fixed costs).

Whereas, a traditional income statement focuses more on profits (gross profit, operating income, and net income).

A contribution margin income statement can only be used internally.

This is because it does not follow the prescribed format by prevailing accounting standards (GAAP and IFRS).

That’s why a publicly owned business will still have to prepare a traditional income statement.

And yes, that is even if it already prepared a contribution margin income statement.

Benefits of preparing a Contribution Margin Income Statement

While it is true that you don’t have to prepare a contribution margin income statement, preparing one is still beneficial for your business.

Here are some of the benefits that a contribution income statement can give you:

Better analysis of a product or segment’s performance

Since expenses are categorized as to whether they are variable or fixed, it is much easier to assess whether a product, service, or even segment is profitable or not.

By segregating variable costs from the total expenses, the computation of contribution margin can be done.

The contribution margin can then be used to assess how much a product or segment is performing.

For example, a business has two products: product A and product B.

Product A has a sales price of $200/unit and a variable cost of $160/unit.

Product B has a sales price of $80/unit and a variable cost of $40/unit.

Assuming that the same number of units of both products were sold, which product contributes more to the operations of the business?

At first glance, you might say that it’s product A due to its high sales price of $200/unit which is significantly higher than product B’s $40/unit ($200 – $160).

However, that isn’t necessarily true.

To get our answer, we must compute the contribution margin (sales price – variable costs) of each product.

Product A has a contribution of $40/unit ($80 – $40), whereas product B also has a contribution margin of $40/unit.

So in truth, both products contribute the same amount to the operations of the business (on a per unit basis)

Helps in identifying which variable costs eat up too much of the revenue

Of the two groups of expenses (variable and fixed), it is much easier to control variable expenses.

As such, if a business wants to decrease costs to increase profits, it would usually look into the variable costs that it can reduce.

Since a contribution margin income statement categorizes expenses according to whether they are variable or fixed, it’s much easier to identify which variable expenses can be reduced.

Additionally, it’s also easier to identify which expenses eat up most of the revenue.

With such information, the business can plan on what to do with such expenses.

For example, if a certain raw material eats up most of its finished good’s sales price, then the business may decide to switch to a cheaper raw material or find a supplier that can offer the same raw material for a much lower price.

Can be used for break-even analysis

Break-even is a point in which revenue and expenses are equal.

Since a business typically has variable and fixed expenses, its break-even point cannot be zero.

Meaning, it will have to earn a minimum amount of revenue to cover its expenses.

It cannot be zero since it has fixed expenses, which are incurred whether a business makes a sale or not.

The formula for computing the break-even point is as follows:

Break-even Point (Units) = Fixed Cost ÷ (Sales Price per Unit– Variable Cost per Unit)

-or-

Break-even Points (Units) = Fixed Cost ÷ Contribution Margin per Unit

As can be seen from the formula above, computing the break-even point involves the contribution margin, which is something that a contribution margin income statement provides.

This is why a contribution margin statement is much more suitable for break-even analysis than a traditional income statement.

Easier to understand the effect of changes in the level of activity

A contribution margin income statement presents present its data in a way that makes it easier to understand the effects of increases or decreases in the level of activity.

This is because it shows the contribution margin which is directly influenced by the level of sales.

Preparing a Contribution Margin Income Statement

Since a contribution margin income statement doesn’t have to comply with accounting standards, it is much more customizable.

Preparing a contribution margin income statement is typically easier than preparing a traditional income statement.

The data that you have to gather are the following:

• Revenue (can be itemized on a per product or segment basis)
• Expenses (itemized as much as possible)

After gathering the data you need, the next step is to categorize the expenses.

Determine whether they are variable or fixed.

To easily identify which expenses are variable or fixed, remember these two points:

• Variable costs are expenses that increase or decrease along with the level of activity; a common example of variable cost is the cost of raw materials used in the manufacturing of a product
• Fixed costs are expenses that remain the same whatever the level of activity is unless an increase in the level of activity prompts a step cost situation; a common example of fixed cost is the cost of renting office space to house the business’s administrative function

Now that we have our revenue, variable costs, and fixed costs, the next step is to construct our contribution income statement.

While it is customizable, there is a general structure that we can follow:

Example

We gathered the following data regarding Company X’s operations:

• It sells a certain product called Brand X at $200/unit
• For every product it sells, it incurs a variable cost of $120; it consists of $50 direct labor and $70 direct materials
• Every month, it incurs a total fixed cost of $12,000 consisting of $5,000 rent, and $7,000 in salaries
• For the month of April 2021, Company X produced and sold 300 units

We are tasked to prepare Company X’s contribution margin income statement.

First, we must get our total revenue figure:

Revenue = Selling Price per Unit x # of units sold

= $200 x 300

= $60,000

Next, we determine the total variable costs:

Total variable costs = Variable Cost per Unit x # of Units Sold

= $120 x 300

= $36,000

Now that we have the data we need to prepare our contribution margin income statement, let’s prepare one:

The contribution margin of $24,000 is the result of deducting total variable cost of $36,000 from the revenue of $60,000.

Subtracting the total fixed cost of $12,000 from the contribution margin well result in a net income of $12,000.

Article Sources & Citations

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1. Harper College "CONTRIBUTION MARGIN INCOME STATEMENT" Page 1 - 10. December 21, 2021

2. Pacific Lutheran University "Contribution Margin" Page 1 . December 21, 2021

3. Cuyamaca College "Cost-Volume-Profit Analysis" Page 1 - 4. December 21, 2021

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