Contribution Analysis

Measures how much an individual product or the company, as a whole, has to contribute to the coverage of fixed costs and then profits.

A contribution analysis (CA), as per its name, measures how much an individual product or the company, as a whole, has to contribute to the coverage of fixed costs and then profits. It's the study and assessment of how direct and variable costs affect net income.

It is a relatively easy analysis done by management that can help analyze current product offerings and make decisions between future products. 

It is used to determine how changes in sales revenues and variable costs impact a company's net income, and it does this by measuring the profitability of individual products or product lines within a company. 

Thus, a contribution analysis can measure the direct impact of each product and then compare them to each other to make relevant decisions.  

There are many different uses of a contribution analysis, and it can be altered depending on a company's needs. 

Some of the ways it can be used are to

  • Develop statements on a unitary basis rather than comparing overall figures. 
  • Compare products or product lines by breaking down the contribution towards the coverage of fixed costs. 
  • Set selling prices with an ideal contribution. 
  • Compare or make changes to the selling price by comparing the contribution of each product. 
  • Make pricing decisions with certain target profits in consideration. 
  • Conduct further analysis (e.g., break-even) 

Contribution analysis: Fixed v/s Variable Costs

To fully understand contribution analysis, you have to be aware of the different cost breakdowns or allocations a company uses. 

This analysis works by allocating direct costs and variable costs and separating them from overhead, also known as fixed costs that are incurred throughout. 

Overhead costs are expenses that stay fixed and do not change with fluctuations in production. Fixed costs are not directly related to any product but are vital for a company's operations. 

Fixed costs under contribution analysis are considered to be non-inventoriable costs.

They aren't considered to be a part of the unit product cost. Rather, it's considered to be expensed during the period. Making it a period cost. They remain the same under absolute terms as the production varies. Changes under the per-unit basis. 

As production increases, per-unit fixed cost decreases and vice-versa.

Examples of fixed costs include: 

  • Rent 
  • Insurance 
  • Salaries 
  • Property tax 
  • Depreciation 

Variable costs, on the other hand, are expenses that change with fluctuations in production. They are directly related to specific business activities. As production increases, variable costs increase. As production decreases, variable costs decrease. 

This means the variable costs are dependent on production. The total of variable costs is the product of variable cost per unit times the number of units budgeted or produced. The variable costs are constant on a per-unit basis. And varies in total.

Examples of variable costs include  

  • Utilities 
  • Production supplies 
  • Raw materials 
  • Commissions/wages 

It's important to understand the cost breakdowns of a company, as it determines what an ideal contribution margin is. If a company has relatively low fixed costs, then a smaller contribution margin is alright. 

However, if a company has a significant amount of fixed costs, then a higher contribution margin is needed to ensure the profitability and survival of the company. 

Most companies tend to aim for a higher margin as fixed costs are considerable. It also means there is more money left to go towards earnings. 

Calculating contribution 

The analysis can be split up into contribution margin (CM), also known as a unit contribution, which is the absolute dollar amount, and contribution margin rate (CMR), which is the percentage or ratio.

It can also be calculated on a per-unit basis by finding out the difference between the per-unit selling price and variable cost-per-unit.

Contribution margin formula 

There are two ways to calculate contribution margin. The first way is to use revenue and total variable costs. 

Contribution Margin = Total Revenue (TR) - Total Variable Costs (TVC)

The second way, known as the unit contribution, is using the selling price and the variable cost per unit of that product. 

Unit Contribution = Selling Price (SP) - Variable Cost per Unit

Unit contribution can also be calculated using contribution margin if the number of units sold is known.  

Unit Contribution = Contribution Margin Number of units sold

While both produce different answers, they both reflect how much money is remaining that can go towards your fixed costs, whether as a total or from the sale of each unit. 

Contribution margin rate formula 

The contribution margin rate (CMR), expressed as a percentage, is the amount of revenue made from a product or the company that goes towards fixed costs and then earnings. 

CMR

Interpreting Contribution Margins 

Contribution margins can be negative or positive. Most companies want to have a high and positive contribution. 

If the contribution is negative, this indicates that a company is not covering its variable costs or that product is not profitable. 

In the long run, this is not sustainable, and the company should consider discontinuing said product or service. An alternative to discontinuing the product would be to improve it. The management may derive one or two alternatives.

Price it differently - the correct course would be to increase the price. Or make efforts to minimize/optimize the variable and direct costs of production.

If the contribution is positive, this means that the company can cover its variable costs and has money remaining to cover its fixed costs. 

Companies have to ensure that margins are high enough so that they can cover all fixed costs. If not, a company can try to reprice its products or sell more. 

Some companies may forgo a high contribution margin for some products as a strategy. For instance, a company may price a phone lower and decrease the margin to draw consumers in. 

Then, the company would price accompanying accessories like chargers and headphones higher to offset the lower contribution on the phone. 
In order to make this clear, let's say that a company sells two products, Product A and Product B. 

cosmetics

Product A has a contribution margin ratio of 60%. This means that 40% went towards covering variable costs, and a company has 60% of its revenue remaining to cover fixed costs. 

One way to intercept this is that for every $1 a company makes in sales, it has 60 cents left to go over fixed costs and then earnings.  

Product B has a contribution margin ratio of 30%. Thus, 60% went towards variable costs. For every $1 made, 30 cents are left to cover fixed costs and go towards profit. 

Product A provides a higher margin compared to B. Thus, if the company had to decide to stop the production of one product, it can compare the contribution margins and see that Product B should be discontinued. 

Examples

Here are comprehensive examples that will go through all the steps of calculating a contribution margin and the potential conclusions that can be made from them. 

cosmetics 2

Suppose a company sells 3 different products - Product A, Product B, and Product C. The following charts will give some information on the cost breakdown of these products in order to calculate the contribution margin rate and do some potential analysis. 

From this example, the CMR is positive, which is a good sign. While the fixed costs of the company are unknown, Product A will contribute 58% of its sales revenue to cover fixed costs.

example

From this example, the CMR is negative, which is a bad sign. Product B is unable to cover the costs of making the product and should be under review. This means that it is costing the company more money to sell it than it is returning. 

Product C, like Product A, also has a positive contribution; this is just another way a company could present its numbers for analysis. 

Overall, Product B seems like a point of concern for the company, and they should monitor the product's performance. It's a point of concern since product B is unprofitable and could be adversely affecting the overall profitability of the organization.

The company has the choice to conduct further analysis to determine a good price point that would return a positive contribution; it can work to improve the product or stop production for Product B. 

Further uses of contribution

After conducting a contribution analysis, the contribution can also be used to conduct a break-even (BE) analysis. The break-even point is where the business does not earn a profit or a loss. This means that the company makes $0 and only makes enough money to cover its costs. 

law

Essentially, the company's revenues equal its expenses. 

A break-even analysis can be used to determine the number of units a business needs to sell to break even, the BE sales figure, and the target profit break-even. This can then be further used to calculate what percentage of the market you need to capture to break even during any given point. 

If the company sells multiple products, the contribution margin rate can further be used to calculate the weighted average contribution margin rate (WACMR). The WACMR is the average amount a group of products can contribute to the company's fixed costs and then profit. 

Most companies would group together products that are similar or complementary. For instance, Charlotte Tilbury, a make-up company, could group together all their lip products and calculate the weighted average contribution margin rate. 

The WACMR, similar to the CMR, can also be used to calculate break-even points. 

FAQs

Excel Modeling Course

Everything You Need To Master Excel Modeling

To Help You Thrive in the Most Prestigious Jobs on Wall Street.

Learn More

Researched and authored by Pooja Patel | LinkedIn 

Uploaded and revised by Omair Reza Laskar | Linkedin

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: