The Contribution margin Income Statement – Why is it important?

The income statement is of great value and importance to a business, as it shows the whole story of a business transactions during a particular period of time. While it measures a company’s financial performance over an accounting period, it shows the entity’s net profit or loss incurred over a specific accounting period presenting how much money a company made and spent.  It is one of the three main financial statements. The other two are balance sheet and cash flow statement.

Since it’s the traditional income statement, it is used commonly in every business entity. The purpose behind the preparation of the traditional income statement is to show the classification of costs in terms of manufacturing or non-manufacturing expenses while showing the operating results of a business thereof.  In traditional income statement, cost of goods sold, variable and fixed costs, are subtracted from sales revenue in order to get gross profit figure. And then marketing and administrative expenses, variable and fixed, are subtracted from gross profit figure so that the net operating income may be determined.

However, there is an alternative format of income statement which is known as the contribution income statement- also called as 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.

In a contribution margin income statement, the computation is done in this way that the variable cost of goods sold is subtracted first from sales revenue, so that the gross contribution margin may be obtained. Then the variable marketing and administrative expenses are subtracted from gross contribution margin in order to get contribution margin. Subsequently, after the contribution margin figure is determined, the net operating income is ascertained by subtracting all fixed expenses from contribution margin figure.

Every business necessitates the process of planning and decision making. In this way, the contribution income statement is very much useful in planning and decision making process of a business entity, as it deals with the costs by behavior showing the relationship between variable costs and the fixed costs, unlike the traditional income statement, that provides the information in terms of the function of costs. It is with the help of contribution margin analysis a distinction can be made between the variable costs and the fixed costs through which the extent to which there has been contribution may be identified. The contribution margin is the excess over variable costs. That is, the amount which is available to meet the fixed costs or expense. This will help a business entity to ascertain whether it is capable enough to cover the fixed costs or not.

Since every business is interested in profit planning constantly, the preparation of contribution income statement enables managers or the concerned people to undertake the profit planning activities by providing great insights. It shows the break-even point that represents the level at which the sales revenue equals the variable costs and the fixed costs.Your break-even point is the point at which total revenue equals total costs or expenses. At this point there is no profit or loss – in other words, you ‘break even’.  It must be noted that the break-even point is the amount of revenue that a company needs to generate to cover its costs and expenses. If a company has additional sales revenue above the break-even point, it indicates that it is making profits. Similarly, if the contribution margin is less than the break-even point, it means that the company is being operated at a loss. Thus the contribution income statement or the contribution margin income statement helps to calculate a company’s margin of safety enabling us to control the variable costs in order that the profitable operation may be created, while it aids greatly in determining the desired income or target income.

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Written by:
K. A. Fareed (Fareed Siddiqui)
Writer, Trainer, Author, Blogger, Software Developer
BBA, MBA-Finance, MPhil-Financial Management, (MSc-Software Engineering)
(PhD-Management)
MA-English, MPhil-English
Post Graduate Diploma in Computer Applications and Programming
Certificate course in English language proficiency
Level 1 – Leadership and Management ILM – UK
Pursuing CMA-USA
Individual Member of Institute of Management Consultants of India