As a business owner, you’ve likely prepared a traditional income statement, with the usual line items for revenue and expenses, with net income on the bottom line.
This standard format can give you a great financial snapshot of how your business is doing. But if you’d like to dig deeper and shed light on how costs affect your profit, a contribution format income statement can help.
Here’s what you need to know about contribution format income statements, how to structure them, and how they can benefit your business.
What is a contribution format income statement?
A contribution income statement is an income statement that separates the variable expenses and fixed costs of running a business. Variable expenses are subtracted from sales to calculate the contribution margin. Then, fixed expenses are deducted to show the final operating income.
Variable expenses fluctuate based on the business’s usage or output, such as utility bills or raw materials. Fixed production costs, such as rent or salaries, remain constant, regardless of business activity or output.
Contribution margin income statements can help business managers control costs, set prices, and make decisions about business segments, such as expanding profitable product lines or discontinuing less profitable ones. These financial statements are primarily for internal use by managers. Traditional income statements are for regulators and investors because they meet generally accepted accounting principles (GAAP), a set of rules the US Securities and Exchange Commission (SEC) requires in the preparation of financial statements of publicly traded companies.
A contribution margin income statement reaches the same bottom-line result as a traditional income statement. While the contribution format sorts costs by whether they are variable or fixed, a traditional income statement separates costs by whether they are tied to production or not. These include the cost of goods sold (COGS) as well as selling, general, and administrative costs (SG&A). The two expense categories may contain both fixed and variable costs, which is why it can be useful to separate them using a contribution format statement.
The contribution format income statement is also known as a contribution margin income statement or a variable-cost income statement.
Example of a contribution margin income statement
Using a hypothetical company, let’s look at how a contribution margin income statement compares to a traditional income statement.
ABC Cabinets Inc. makes bath and kitchen cabinet sets and sells fixtures such knobs, handles, and faucets. A contribution format income statement, might look like this (in US dollars):
|Sales of cabinet sets||1,600,000|
|Sales of fixtures||900,000|
|Materials, hourly labor||1,100,000|
|Storage, shipping, utilities||150,000|
|Total variable costs||1,250,000|
|Contribution margin (sales – variable costs)||1,250,000|
|Total fixed costs||200,000|
|Operating income (contribution margin – fixed costs)||1,050,000|
By comparison, a basic traditional income statement might look like this:
|Cost of goods sold (COGS)||1,350,000|
|Gross profit (revenue – COGS)||1,150,000|
|Selling, general, administrative costs (SG&A)||100,000|
|Operating income (Gross profit – SG&A)||1,050,000|
Both methods lead to the same operating income, though they arrive via a different route.
Contribution margins also can be expressed as ratios. The formula is:
(Revenue – Variable Costs) / Revenue = Contribution Margin Ratio
From the statement above, we can see ABC’s contribution margin is 50%:
($2,500,000 – $1,250,000) / $2,500,000 = 0.5 or 50%
ABC Cabinets can use the contribution format for segment analysis, evaluating its two business segments and their relative contribution margins. Managers would have to determine the allocation of variable and fixed costs to each segment. Let’s say the allocations are as shown below.
|Materials, hourly labor||900,000||100,000|
|Storage, shipping, utilities, selling||100,000||150,000|
|Total variable costs||1,000,000||250,000|
|Contribution margin (sales – variable costs)||600,000||650,000|
|Contribution margin ratio||37.5% (600,000 / 1,600,000)||72.2% (650,000 / 900,000)|
|Marketing, salaries, payroll/accounting||75,000||75,000|
|Total Fixed Costs||100,000||100,000|
|Operating income (contribution margin – fixed costs)||500,000||550,000|
ABC Cabinets can also use contribution margin analysis to understand each product segment’s break-even point, or the point where it begins to make a profit. A break-even analysis can help a company determine how much in dollar sales it must generate to break even.
Determine the break-even point using the following formula.
Fixed Costs / Contribution Margin Ratio = Break-even Sales
For example, for the cabinets segment the break-even sales point would be:
100,000 / 37.5% or 0.375 = $266,667
For fixtures, the same formula produces the following result:
100,000 / 72.2% or 0.722 = $138,504
Managers at ABC Cabinets would conclude from segment analysis that the fixtures segment is more profitable because it has a higher contribution margin. Using the formulas above, they could also see that the cabinet segment needs to generate almost double the sales compared to the fixtures segment to reach the break-even point.
What’s the difference between a contribution format and a traditional income statement?
A contribution format statement differs from a traditional income statement in several ways:
Contribution format statements separate expenses into fixed and variable costs. Traditional income statements separate costs by production (COGS) and administration (SG&A), each of which may be a mix of variable and fixed costs. Each method results in the same operating income.
Traditional statements calculate gross profit margin, which is determined by subtracting the cost of goods sold (COGS) from revenue. Contribution format statements produce a contribution margin, which is the result of subtracting variable costs from revenue. Variable costs are less than COGS, which also may include fixed and variable costs, so a business’s contribution margin is usually higher than its gross margin.
General vs. specific
Traditional income statements are used to evaluate the overall profitability of a business. Contribution formats are more detailed, and are useful for evaluating business segments, such as subsidiaries or divisions, or individual product lines. They’re also useful for managers determining how sensitive variable costs are to a change in sales or production.
Internal vs. external use
Contribution format statements are for internal use by businesses. Traditional statements are required because they conform to GAAP accounting standards, and they are prepared for external audiences, including investors, lenders, and regulators.
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Contribution format income statement FAQ
How do you calculate the contribution margin on an income statement?
First determine what portion of COGS and SG&A are variable costs that rise or fall with sales or production. Once you’ve done that, subtract those costs from sales or revenue to arrive at the contribution margin. The formula for contribution margin is: Revenue – Variable Costs = Contribution Margin
Is gross profit the same as contribution margin?
Your gross profit and contribution margin are different because of the way they allocate costs. The contribution margin excludes fixed overhead costs, whereas COGS usually includes some overhead as part of direct production costs. The result is that a company’s contribution margin is almost always greater than its gross profit.
What is the difference between a variable-cost income statement and a contribution margin income statement?
They are the same. A variable-cost margin is also known as a contribution margin.
What are some advantages of contribution margin income statements?
A contribution margin statement allows businesses to determine which products or business segments are most profitable. They also allow a business to conduct a break-even analysis to determine the point at which they become profitable, in whole or by a business segment or product line.