As a business, analyzing your financial performance for an ended period is an invaluable tool to planning for the next one. The Contribution Margin Income Statement provides such an analysis by reviewing your financial statements to calculate your net profit or loss. It is not a financial reporting statement but one that helps you gauge the success of a period by coming up with a value called net income.
Generally, this statement answers the crucial question of whether you recorded a profit (made more than you used) or a loss (spent more than you made). It also tells you whether you should make any adjustments to your spending and production.
What Is a Contribution Margin Income Statement?
A contribution margin income statement calculates the net profit or net loss of a financial period by deducting variable expenses from sales and deducting fixed costs from the result (called a contribution margin). It also assigns every expense by nature as either fixed or variable. Additionally, it produces the contribution margin, which informs you how much funds you have from which to pay for fixed costs and make a profit or loss.
The contribution margin is found by deducting the variable expenses from the sales. If a business makes no sales, the contribution margin is recorded as zero and increases as the sales rise. Fixed costs, which are subtracted from the contribution margin to produce the net income or loss, are often constant.
Variable and Fixed Expenses
A contribution margin income statement bifurcates total expenses into a variable and fixed expenses when calculating the contribution margin. Fixed expenses are costs that tend to stay constant over time and have no direct relation to production levels. Common examples include:
- Property rent payments
- Equipment rent
- Storage space fees
- Employee salaries
Variable costs, on the other hand, are expenses that change constantly and increase or decrease the production levels when they do, such as energy costs.
Calculating Contribution Margin
Preparing the contribution margin income statement requires that you first calculate the contribution margin. You can do this as long as you have data on your variable expenses and sales revenue. With this information, determining the contribution margin involves using this formula:
Contribution margin (percentage) = Sales – Total variable expenses ÷ Sales (×100)
For instance, for a period with 200,000 in sales and 50,000 in total variable expenses, the contribution margin is 150,000 ÷ 200,000, or 75%.
Calculating Your Contribution Margin Income
With the contribution margin calculated above, you can now calculate the contribution margin income. You will need data on the fixed expenses (production, sales, administrative) and the following formula:
Net profit or Net loss = Contribution margin – Total fixed expenses
In the above example, if the fixed expenses are $ 50,000, the company will record a profit of 150,000 – 50,000 = 100,000. If they were 200,000, the company would record a $50,000 loss, which they must compensate for by reducing fixed expenses or increasing sales.
If they choose to decrease expenses, they must do so by 50,000. Otherwise, they must increase sales to the amount found by using the following formula:
Loss ÷ contribution margin (percentage)
Using the same example, the business must increase its sales by $66,667 ($50,000 ÷ 75%)
After a financial period, a business can either make a profit or loss or break even. Breaking even is a situation where the total sales revenue amount is equal to the total expenses, otherwise called the break-even point. This point is usually calculated in sales dollars or units. If you choose the latter, you can use the following formula:
Break-even point (units) = Fixed expenses ÷ (Sales per unit – Variable expense per unit)
Alternatively, you can calculate the break-even point in sales dollars using the following formula:
Break-even point (sales dollars) = Fixed expenses ÷ Contribution margin
Consider a business that sells 500 units and makes a net profit of $500,000 with variable expenses of $200,000. The sales per unit will be $1,000 ($500,000 ÷ $500) and the variable expenses per unit $400 (variable costs ÷ sold units).
Substituting the values in the unit formula: (At the break-even point, the fixed expenses will be equal to the net profit – variable costs).
$300,000 ÷ ($1000 – $400) = 500 units
The business will need to sell 500 units to break even during this financial period. If they sell 499 units, they will make a loss while 501 units will present a profit. Regardless of whether you use units or values when calculating the break-even point for a financial period, use them consistently to avoid frequent conversions (unless you can easily do them). You should also consider using units when presenting the document to people keen on operations and values for those keen on finances. You can also use both methods within the same document for ease of use.
Contribution Margin Income Statement Vs. Normal Income Statement
The Contribution Margin Income Statement is sometimes called a special format income statement, mainly because it is derived from a normal income statement. Besides this fact, nonetheless, the two documents differ in the following ways:
- A normal income statement calculates the gross margin with the contribution margin income statement works with the contribution margin.
- A normal income statement aggregates fixed production costs lower than the contribution margin income statement.
- The contribution margin income statement groups variable administrative and selling expenses together when calculating the contribution margin.
Advantages of Contribution Margin Income Statement
The contribution margin income statement is popular in the corporate world for the following reasons:
- It uses a highly organized format that allows you to follow the effect of production and sales changes on profit.
- It provides a more in-depth analysis of a company’s financial performance for a given period, despite the numbers not changing.
- It divided the variable and fixed expenses, allowing for better analysis.
- It helps calculate the break-even point.
- It can pinpoint the variable expenses that are creating a revenue leak.
Disadvantages of Contribution Margin Income Statement
This statement also has drawbacks, which include:
- It is highly skewed toward expenses.
- It cannot be presented to external audiences because the GAAP does not recognize its format.
The Contribution Margin Income Statement is a financial statement derived from the income statement to determine the net income and net profit or loss of a given period. It incorporates four elements: fixed expenses, variable expenses, sales, and the contribution margin to make these calculations. From the statement, you can determine the profitability of your business and pinpoint which activities are contributing to your losses.