Contribution Margin-It’s importance for tracking success!

Contribution Margin Analysis is a measure of operating leverage: It measures how growth in sales translates to growth in profits.

The contribution margin is computed by using a contribution income statement: A management accounting version of the income statement that has been reformatted to group together a business's fixed and variable costs.

Contribution is different to Gross Margin that a contribution calculation seeks to separate out variable costs (included in the contribution calculation) from fixed costs (not included in the contribution calculation) on the basis of economic analysis of the nature of the expense whereas gross margin is determined using accounting standards.

The unit contribution margin is calculated by deducting the unit variable costs from the unit-selling price:

USP - UVC = UCM

Selling price per unit 100.00 -
Variable cost per unit 80.00

$100.00 - $80.00 = $20.00

Unit contribution margin 20.00 (20%)

Academic gurus are bounding about the country these days decrying the antiquity of certain accounting practices while advocating the desirability of "newer" methods. One of the techniques receiving derogatory attention is the contribution margin approach to decision making. These critics will contend that contribution margin analysis no longer provides relevant information for product costing and decision making. They cite, in generalities, the experience of Asian manufacturers, very large mass production operations and other complex production companies as proof of their claims and then buttress these claims with anecdotal corroboration normally drawn from a case study in a large complex corporation.

These critics imply that strategies for large, complex firms apply equally to all manufacturers and distributors. Contribution margin accounting, however, is more useful than ever to many small to medium sized manufacturers who find that they inherit the inventory problem from their large customers and to companies too small to gain any advantage from "cell group production" organization.

For these smaller producers, the entire production facility comprises a more tightly knit unit than many cell groups in the larger companies. As a new job starts, the production elements work together to produce the items ordered performing the tasks needed to complete the job. Elaborate reporting requirements prove unnecessary and often nonexistent for these small manufacturers. Support functions tend to exist at the shop floor within close proximity to the production facility. While multiple jobs may run simultaneously, the work force typically knows the various jobs, their importance to the organization and what resources and effort are required to complete the job.

Support services associated with smaller companies tend to be streamlined. Restructuring into cells, rather than simplifying support services, would add to support services and increase overhead. In short, practically everything the production cell accomplishes in the large mass production environment already exists on the factory floor of the small producer.

Furthermore, just-in-time (JIT) inventory concepts do not work as well for small companies as for large mass production facilities. These larger facilities can forecast with reasonable accuracy the activities and materials needed. They can schedule months in advance of the production activity. Most small producers and distributors find that precision in forecasting specific activities often proves impossible. Activities for the small producer or distributor typically follow the whims of the marketplace and prove fairly erratic.

Each shipment of parts received for short-term production (daily or weekly) at the large producer constitutes a large quantity (truckload, rail car load or train load) in the shipment. The small producer or distributor faces daily or weekly quantity needs comprising a small shipment. The transportation costs associated with the shipments may prohibit the elimination of inventories of raw materials, parts and finished products for these producers. Likewise, set-up costs for the small job shop may be significant enough to justify single runs of production and warehousing of overproduction of finished goods inventory.

Dangers of Full Costing in Small Manufacturing

A small manufacturer in Ohio recently had its cost accounting system evaluated to determine requirements for bringing it inline with JIT-type cost measures. The Chief Operating Officer (COO) complained that overhead costs were 800% of direct labor, whereas just two years prior those costs were running 120% of direct labor. The investigation revealed that the cost system measured overhead in pools and allocated both fixed and variable overhead to the products based on direct labor dollars at all stages of production.

Two years ago, the COO evaluated the fabrication operations and, based on the full cost analysis, determined that the company should buy rather than make all the parts used in production. The company proceeded to farm out all the fabrication operations to other producers while still maintaining the same operations facility. The result was fewer labor dollars to spread fixed costs over, while fixed costs remained the same.

Had that COO considered a contribution margin approach to unit costs when comparing the make vs. buy option, the company would still be fabricating all of its parts. In every case, the variable costs and incremental fixed costs associated with the fabricated parts were significantly less than the option to purchase outside. With this information, the COO would have made the decision to make rather than buy.

Since the decision was made to buy, freight charges on the finished parts increased as the packing required to protect finished parts bought increased. The unpacking and receiving activities increased dramatically, driving up handling costs. With full cost analysis, all these factors were ignored when the COO arrived at the decision to buy rather than make the parts used in the final assembly.

Small manufacturers find competition tight and difficult, while their large customers continue to put pressure on them to produce to specifications and to a time schedule that may prove difficult. Contribution margin accounting provides information essential for the small manufacturer to balance these factors and continue profitably.