Contribution Analysis is useful in understanding the effect of direct and variable costs on the net income. Simply saying, such an analysis helps a company understand the importance of each product and line item in the business. It also helps managers assess the overall effect of a unit on the company as different metrics such as variable costs etc., change.
Specifically, it helps a company understand the contribution of individual business lines or different products by calculating the contribution margin of each in terms of dollars and percentages. To arrive at the contribution margin, direct and variable costs related to the manufacturing process are subtracted from the revenue.
Suppose the contribution of products is 10%, which is lower than other products of a business. If a company is unable to lower the variable costs of this product, it may eventually decide to drop the product.
Moreover, contribution analysis is done to understand the strong and weak points of the business or the product. It also tells how each unit helps in recovering the fixed income cost.
During contribution analysis, the managers also consider the effect of internal and external factors.
Contribution Margin Calculation
Formula to calculate Contribution in dollars per unit is (Total Revenue- Variable costs)/Number of units sold.
For example, a company sells 15,000 units of shirts for a total revenue of $400,000. Cost of goods sold is $150,000, labor expenses of $100,000. The contribution margin per shirt is ($400,000 – $150,000-$100,000)/15000 = $10.00 per shirt.
Uses of Contribution Analysis
Contribution Analysis is done largely to support the decision-making process. For better results, a company uses such analysis along with the budgeting process and management accountant functions. Below are the various use cases of the contribution analysis;
Arriving at Minimum Selling Price of a Product
Companies always look to set prices that are competitive. However, at the same time, the set price should cover the fixed and variables cost. But, in certain situations like excessive inventory or other external factors, a company might have to lower the price to clear the stock. In a situation like this, managers can quickly arrive at a suitable price using the contribution analysis.
Profit Volume Chart
Not every manager is technical, and therefore, a graph helps them with an easy understanding of the concept. A Profit Volume chart explains the relationship between volume and profit through graphical representation. In the graph, the contribution figure is considered as a variable. Through this graphical representation, managers are able to understand the profit at a given level.
Calculation of Break Even
Startups need to reach break-even before generating profit. For those unaware, a break-even point is where the business makes no profit or loss. One can calculate the break-even point using a formula – Fixed cost/Contribution per unit.
Every business needs to calculate a margin of safety to come up with future strategies. One can easily do so by using contribution analysis. To make it easier for the managers, contribution analysis is expressed in percentage terms. For instance, if the break-even unit is 2,500, it means the company would be profitable once they sell the 2501st unit.
In case the company has set a target of selling 5,000 units, then the margin of safety would be (5,000-2,000)/5,000 *100 = 50%
Advantages of Contribution Analysis
Ease of Use
This metric is relatively easier to use and understand. Thus, it is effective in helping managers to arrive at decisions. Understanding the exact amount of profit that each unit would start generating beyond the break-even point gives the company a better picture of its performance. Contribution analysis alone helps in understanding some of the most critical points in profit.
When calculating the margin of safety, a manager is basically doing contingency analysis. To be aware of the exact number of units to be sold to stay above the margin of safety is beneficial for the company.
In Contribution Analysis, the assumptions can sometimes be far from reality. Assumptions such as constant selling price or linear pricing are some of the shortcomings of this approach. To overcome this, managers can make the guesstimates, but it depends on the personal capacity of the manager to access the situation.
There is another approach of contribution analysis that is more in line with its name, i.e., analyzing the contribution. This approach does not limit production cost, revenue, or a company, but instead to any program, a social cause, a political campaign, economic analysis, etc.
Under such an approach, a contribution analysis helps managers, researchers, and policymakers to understand the contribution of their program to a particular outcome. Therefore, such an analysis lowers the uncertainty about the contribution by evaluating results, roles, and other internal and external factors.
Such an analysis is helpful for programs that are not experimental and where there is little or no scope in varying the implementation of the program.
Steps for Contribution Analysis
There are a few steps that help to come up with a contribution analysis. Such steps can prove useful in both approaches of contribution analysis. These steps are:
- Set out the problem that you need to find a solution for.
- Develop the process and factors involved.
- Gather data on the factors and parameters.
- Analyze the performance on the basis of data.
- Make sure you don’t miss anything. If you miss any data, then add it and analyze the performance again.
- Keep revising the data from time to time to ensure it remains effective.
A point to note is that the contribution analysis is not a conclusion in itself. Instead, it offers evidence and reasoning, which one can use to arrive at a meaningful conclusion.