By Paul B. Finch, MBA | 8/19/2022

The traditional Income Statement Approach classifies costs according to the reason costs were incurred and yields a Profit Calculation for your business as a whole. While this is a good measure for understanding the profitability of your entire business, it is not an effective method for measuring the contribution that individual products make to your company’s bottom line. For this, you need to utilize a Contribution Margin Approach.

The Contribution Margin Approach

As opposed to the traditional Income Statement Approach which classifies costs according to the reason costs were incurred, that being Cost of Goods Sold or Sales, General and Administrative Expense, a Contribution Margin Approach classifies costs according to a cost’s behavior, that is Variable or Fixed. A such, your products’ Contribution Margins are calculated as follows: Revenue Per Unit minus Variable Expense Per Unit equals Contribution Margin.

Notice that Fixed Costs are not used to calculate the Contribution Margin. This is because Fixed Costs do not change based on the number of product units sold unlike Revenue and Variable Expense which do change proportionally based on the number of product units sold. Use of the traditional Income Statement Approach to analyze a product’s profitability can result in a misleading and erroneous conclusion when changes in price and volume occur. This is because the Income Statement Approach, as applied through a Standard Absorption Cost Accounting System, not only assumes that Revenue and Variable costs change in proportion to changes in price and volume, but also implicitly assumes that Fixed Costs change in proportion to changes in price and volume which is factually incorrect.

While Standard Absorption Costing has required applications in External Financial Reporting and Tax Accounting, it is not appropriate for financial planning, analysis, and financial decision making. A Contribution Margin Approach is the preferred method for understanding how a specific product, or a mix of products, contributes to your company’s profitability.

Variable versus Fixed Costs

A cost’s behavior is Variable if it changes in proportion to changes in Revenue. Examples of Variable Costs are as follows: (i) Manufacturing/Production Labor; (ii) Supplies used in Manufacturing/Production; (iii) Shipping Costs; and (iv) Sales Commissions.

A cost’s behavior is Fixed if it does not change in proportion to changes in Revenue. Examples of Fixed Costs are as follows: (i) Administrative Wages/Salaries; (ii) Facility Rent; (iii) Advertising; (iv) Property Taxes and Licenses; and (v) Sales Persons’ Base Wages/Salaries.

It is important to note that Fixed Costs remain fixed within a Relevant Range of production. At some point, when production reaches certain volumes (known as an “Inflection Point”), it is necessary to increase Fixed Costs to accommodate increases in product demand. It is at this Inflection Point when Fixed Costs enter a new Relevant Range.

Application of the Contribution Margin Approach

A product’s Contribution Margin is the amount contributed to pay for a business’ Fixed Costs. Accordingly, the greater a product’s Contribution Margin, the sooner the firm reaches its breakeven point and achieves profitability, all other things remaining equal. Conversely, products that have a negative Contribution Margin lose money for each unit sold and are considered to be at the economic shut-down-point, that is the point when a product should be discontinued.

A Contribution Margin Approach is commonly used in financial decision making as follows: (i) Decisions to Increase or decrease individual product production [or discontinue production in situations where a negative Contribution Margin exists]; (ii) Decisions pertaining to individual product pricing or one-time discounts; (iii) Decisions to introduce new products or change the cost structure of existing products; and (iv) Decisions pertaining to whether to make or buy a given product.

Additionally, when the Contribution Margin Approach is applied to more than one product, you are able to determine the optimal mix of product price and sales volume that achieves your business’ breakeven point most efficiently as well as optimizing your business’ profitability.

Operating Leverage

A Contribution Margin Approach will easily allow you to understand the effect Operating Leverage has on your company’s profitability. More specifically, the lower your company’s Variable Costs [or the greater your company’s Contribution Margin], for individual products or your product mix as a whole, the more your profitability will increase proportionally to the revenue for each product unit sold – this is known as Operating Leverage.

It might intuitively seem that the greater your company’s Operating Leverage, the better. While this is a true statement for a company that has revenue persistence and routinely exceeds its breakeven point for individual products or your product mix as a whole, you need to be aware that increases in Operating Leverage will have the opposite effect for a company that has not achieved revenue persistence and is therefore unable to reach its breakeven point. For these companies, losses will increase proportionally to the revenue for each product unit sold [either for individual products or your product mix as a whole].

Accordingly, it is accurate to say that increases in Operating Leverage increase a company’s financial risk. For this reason, you should take great care and consideration in making decisions to incur Variable versus Fixed Costs as it pertains to the operation of your business.

Getting Started

Recategorizing costs as either Fixed or Variable is not as straightforward as it sounds. This is because a cost’s behavior needs to be analyzed over time, allocated directly to a given product and be consistently applied over the course of any analysis. Likewise, making decisions about whether to increase or decrease production [or discontinue a product line], to make changes to the cost structure of an existing product, or whether to increase or decrease pricing requires careful consideration of all relevant facts. That said, producing a valid and reliable Contribution Margin analysis requires rigor and needs to be applied by persons with proper training, expertise, and experience. As such, it is almost always best to hire an independent Management Accountant to apply a Contribution Margin Approach to support financial decision making.

Final Thoughts

Every company should be examining the Contribution Margin for individual products and their product mix as a whole. The information you gain from looking at profitability from a Contribution Margin perspective is well worth the effort.

Paul B. Finch, MBA, is co-founder and Executive Director for Benchmark Solutions, Inc. and is an accomplished Strategic Financial Advisor. Paul specializes in the areas of Financial Planning and Analysis, Decision Support, Business Valuation as well as M&A Advisory where he applies corporate finance and management accounting processes/methods as a regular part of his practice. You can contact Paul at paul.finch@benchmarksolutions.us.com