Contribution is the amount of earnings remaining after all direct costs have been subtracted from revenue. This remainder is the amount available to pay for any fixed costs that a business incurs during a reporting period.
Direct costs are any costs that vary directly with revenues, such as the cost of materials and commissions. For example, if a business has revenues of $1,000 and direct costs of $800, then it has a residual amount of $200 that can be contributed to the payment of fixed costs. This $200 amount is the contribution arising from operations.
The contribution concept is usually referred to as contribution margin, which is the residual amount divided by revenues. It is easier to evaluate contribution on a percentage basis, to see if there are changes in the proportion of contribution to revenues over time.
Contribution should be calculated using the accrual basis of accounting, so that all costs related to revenues are recognized in the same period as the revenues. Otherwise, the amount of expense recognized may incorrectly include costs not related to revenues, or not include costs that should be related to revenues.
The contribution concept is useful for determining the lowest possible price point at which products and services should be charged, and still cover all fixed costs. Thus, a detailed knowledge of contribution is useful in the following situations:
- Pricing. Special pricing deals should be designed to yield some amount of contribution; otherwise a company is essentially losing money every time it makes a sale.
- Capital expenditures. Management can estimate how expenditures for fixed assets alter the amount of direct costs incurred, and how this impacts profits. For example, an expenditure for a robot can reduce direct labor costs, but increases fixed costs.
- Budgeting. The management team can use estimates of sales, direct costs, and fixed costs to forecast profit levels in future periods.
A common outcome of contribution analysis is an increased understanding of the number of units of product that must be sold in order to support an incremental increase in fixed costs. This knowledge can be used to drive down fixed costs or increase the contribution margin on product sales, thereby fine-tuning profits.