Contribution Analysis

What is Contribution Analysis?

Contribution analysis is used in estimating how direct and variable costs of a product affect the net income of a company. It addresses the issue of identifying simple or overhead costs related to several production projects. Contribution analysis aids a company in evaluating how individual business lines or products are performing, by comparing their contribution margin dollars and percentage. Direct and variable costs incurred during the manufacturing process are subtracted from revenue to arrive at the contribution margin. This is, therefore, a very crucial procedure in the growth of a business.

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Contribution Margin Formula

The formula for contribution margin dollars-per-unit is:

(Total revenue – variable costs) /  # of units sold

For example, a company sells 10,000 shoes for total revenue of $500,000, with a cost of goods sold of $250,000, and a shipping & labor expense of $200,000.

The contribution margin per shoe is ($500,000 – $250,000 – $200,000) / 10,000

Contribution = $5.00 per shoe

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The Pros of Contribution Analysis

Contribution analysis helps in the assessment of how individual products are profitable to the company.

The significance of contribution analysis is that it gives certainty to the profitability of each product and helps you understand why the results are as they are. Contribution analysis clearly indicates the specific external and internal factors that have an influence on a company’s income.

The Cons of Contribution Analysis

Some problems might come up when using this approach, regarding any of the following:

• Real-life evaluations
• Confirmation of the  theories involved
• Relating the observation made by reducing uncertainty

Steps Involved

There are six steps that must be followed in the analysis, as outlined below:

1. Identify the problem to be assessed –  This means pointing out the target that you want to see the cost/profit analysis on.
2. Come up with a change theory and model – This means that you should come up with relevant policies with respect to the problem identified. This will help in understanding how the policies formulated are going to help in influencing change.
3. Gather enough data on the model – It is important to get the existing evidence on the model formulated to ensure that it will be effective.
4. Assess the performance based on the data collected and evidence – One way of getting the required evidence is through stakeholders and witnesses.
5. Dig up additional evidence – This is the stage where new data and evidence is added to the already existing information so that nothing is missed.
6. Revising the performance data and records – This process will help in the rectification of the weaknesses and improvement of the strengths.

Learn More

To learn more, see the CFI resources listed below and check out our financial analysis fundamentals course.

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