The Contribution Margin Income Statement
A contribution margin income statement is an income statement in which all variable expenses are deducted from sales to arrive at a contribution margin, from which all fixed expenses are then subtracted to arrive at the net profit or loss for the period. Thus, the arrangement of expenses in the income statement corresponds to the nature of the expenses. This income statement format is a superior form of presentation, because the contribution margin clearly shows the amount available to cover fixed costs and generate a profit (or loss).
In essence, if there are no sales, a contribution margin income statement will have a zero contribution margin, with fixed costs clustered beneath the contribution margin line item. As sales increase, the contribution margin will increase in conjunction with sales, while fixed costs remain (approximately) the same. Fixed costs will increase if there is a step cost situation, where a block of expenses must be incurred to meet the requirements of an increase in activity levels. For example, sales may increase so much that an additional production facility must be opened, which will call for the incurrence of additional fixed costs.
A contribution margin income statement varies from a normal income statement in the following three ways:
- Fixed production costs are aggregated lower in the income statement, after the contribution margin;
- Variable selling and administrative expenses are grouped with variable production costs, so that they are a part of the calculation of the contribution margin; and
- The gross margin is replaced in the statement by the contribution margin.
Thus, the format of a contribution margin income statement is:
|-||Variable production expenses (such as materials, supplies, and variable overhead)|
|-||Variable selling and administrative expenses|
|-||Fixed production expenses (including most overhead)
|-||Fixed selling and administrative expenses|
|=||Net profit or loss|
In many cases, direct labor is categorized as a fixed expense in the contribution margin income statement format, rather than a variable expense, because this cost does not always change in direct proportion to the amount of revenue generated. Instead, management needs to keep a certain minimum staffing in the production area, which does not vary for lower production volumes.
The key difference between gross margin and contribution margin is that fixed production costs are included in the cost of goods sold to calculate the gross margin, whereas they are not included in the same calculation for the contribution margin. This means that the contribution margin income statement is sorted based on the variability of the underlying cost information, rather than by the functional areas or expense categories found in a normal income statement.
Under both the contribution margin income statement and a normal income statement, the net profit or loss will be the same.
It is useful to create an income statement in the contribution margin format when you want to determine that proportion of expenses that truly varies directly with revenues. In many businesses, the contribution margin will be substantially higher than the gross margin, because such a large proportion of its production costs are fixed, and few of its selling and administrative expenses are variable.