The contribution margin income statement obtains the result of the number of contributions after deducting variable expenses from income. The fixed costs are reduced by the contribution and are the ones that allow us to know the result of the company’s profit or loss.
Although there are different formats to obtain the company’s financial year results, this is a particular format to separate variable and fixed costs. The separation of variable and fixed costs is important because it will allow a clearer determination of the relationship between income/expenditure and profit.
The contribution margin
The contribution margin will be obtained when variable costs are deducted from revenues. This will generate what is called the contribution margin. From the contribution margin, we will subtract the fixed costs and thus obtain the net profit or net loss.
It should note that, usually, income statement formats consider fixed costs as part of the overall costs. That means that they do not value these expenses as part of the cost of production.
It is different from applying a fixed cost to a variable cost. Let’s try to understand this:
- The fixed cost will not depend on the volume of production or the number of services provided: whether we produce 100 pieces or 1000, our fixed costs remain constant.
- Variable costs evolve according to output: it will not be the same for certain expenses to give 100 haircuts in a hairdressing salon or 1000 haircuts in the same period.
On the other hand, separating fixed and variable costs in the contribution statement makes it easier to make strategic decisions about the company’s cost level.
Imagine the cost of a raw material that evolves according to your product quantity. The decisions you make about this raw material are important and they impact expenditure.
And now, imagine that the cost of the water bill, which is fixed for an insurance office, is not set for a car wash business that depends on the number of washes it carries out.
Contribution margin income declaration form
It is not very difficult to understand how to adjust the income format of the contribution margin.
First of all, all revenues are allocated to the contribution margin, and variable costs are deducted from all of them. The number of fixed costs is subtracted after removing the variable costs from what is leftover. The result obtained is the profit or loss margin that the company accumulates.
As you can see, this is very different from an income statement, where costs and revenues are reported thoroughly. Here, expenses are classified according to their behaviour.
As we said before, in variable costs, you will include from the direct labor itself to costs that for other companies could be fixed, but for yours are variable. That is to say, for every expense that varies according to the amount of production, you must include it directly in variable costs.
And the same goes for fixed costs: regardless of the amount of production, you should record every immovable price as a fixed cost.
That will give you a numerical result. However, you can also translate this into a percentage by dividing the contribution margin by the unit price. This way, you get a variable cost rate (and a contribution margin rate).
Advantages and drawbacks of contribution margin reporting
Note that the first thing to do in this format is to replace the gross margin with the variable and fixed costs bifurcation. The constant charges will always be applied after the contribution margin has been obtained. The variable expenses are basic to the calculation of the contribution margin.
The main advantage of this format is that you get much more organized data with a contribution margin. That will allow you to control the different changes in both volume and sales.
Other advantages are:
- It will help you to identify high variable costs so that you can influence them.
- It gives you a more dynamic financial statement than the general statements and even allows you to attack each service or product with its costs and expenses.
- Facilitates much more accurate analyses the more you can separate fixed and variable costs
However, there are also some disadvantages you should be aware of. The most important ones would be:
- It is a format not recognized in GAAP: you cannot share it with other external analysis tools.
- It has a direct focus on expenses
- It is not used from external information: it is analyzed for internal use.
- Strengths and assessment
As we have seen, the contribution margin is a powerful and much-appreciated tool for assessing the relationship between companies’ expenses and revenues.
It is a special format of the income statement that facilitates decision-making. Used well, it will greatly improve the relationship between what your company spends and what it earns for each product or service.