Contribution Margins
One of the important, yet relatively simple, tools afforded by cost/volume/profit analysis is known as contribution margin analysis. Your company's contribution margin is simply the percentage of each sales dollar that remains after the variable costs are subtracted. When you know the contribution margin, you can make better decisions about whether to add or subtract a product line, about how to price your product or service, and about how to structure any sales commissions or bonuses.
How is your contribution margin computed? By using a special type of income statement that has been reformatted to group together your business's fixed and variable costs.
Here's an example of a contribution format income statement:
Beta Sales Company
Contribution Format Income Statement
For Year Ended December 31, 200X |
|---|
| Sales |
$ 462,452 |
|
| Less Variable Costs: |
|
|
| Cost of Goods Sold |
$ 230,934 |
|
| Sales Commissions |
$ 58,852 |
|
| Delivery Charges |
$ 13,984 |
|
| Total Variable Costs |
$ 303,770 |
|
| Contribution Margin |
$ 158,682 |
34% |
| Less: Fixed Costs: |
|
|
| Advertising |
$ 1,850 |
|
| Depreciation |
$ 13,250 |
|
| Insurance |
$ 5,400 |
|
| Payroll Taxes |
$ 8,200 |
|
| Rent |
$ 9,600 |
|
| Utilities |
$ 17,801 |
|
| Wages |
$ 40,000 |
|
| Total Fixed Costs |
$ 96,101 |
|
| Net Operating Income |
$ 62,581 |
|
You can tell at a glance that the Beta Company's contribution margin for the year was 34 percent. This means that, for every dollar of sales, after the costs that were directly related to the sales were subtracted, 34 cents remained to contribute toward paying for the direct costs and for profit.
Contribution format income statements can be drawn up with data from more than one year's income statements, if you're interested in tracking your contribution margins over time. Perhaps even more usefully, they can be drawn up for each product line or service you offer. Here's an example, showing a breakdown of Beta's three main product lines:
| |
Line A |
Line B |
Line C |
| Sales |
$ 120,400 |
$ 202,050 |
$ 140,002 |
| Less Variable Costs: |
| Cost of Goods Sold |
$ 70,030 |
$ 100,900 |
$ 60,004 |
| Sales Commissions |
$ 18,802 |
$ 40,050 |
$ 0 |
| Delivery Charges |
$ 900 |
$ 8,084 |
$ 5,000 |
| Total Variable Costs |
$ 89,732 |
$ 149,034 |
$ 65,004 |
| Contribution Margin |
$ 30,668
(25%) |
$ 53,016
(26%) |
$ 74,998
(54%) |
Although we've only shown the top half of the contribution format income statement, it's immediately apparent that Product Line C is Beta's most profitable one, even though Beta gets more sales revenue from Line B. It appears that Beta would do well by emphasizing Line C in its product mix. Moreover, the statement indicates that perhaps prices for line A and line B products are too low. This is information that can't be gleaned from the regular income statements that your accountant routinely draws up each period.
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