Applications
Contribution arises in Cost-Volume-Profit Analysis, where it simplifies calculation of Net Income, and especially break even analysis.
Given the contribution margin, a manager can easily compute breakeven and target income sales, and make better decisions about whether to add or subtract a product line, about how to price a product or service, and about how to structure sales commissions or bonuses.
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 than Gross Margin in 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. Calculating the contribution margin is an excellent tool for managers to help determine whether to keep or drop certain aspects of the business. For example, a production line with positive contribution margin should be kept even it causes negative total profit, when the contribution margin offsets part of the fixed cost. However, it should be dropped if contribution margin is negative because the company would suffer from every unit it produces.
The contribution margin analysis is also applicable when the tax authority performs tax investigation, by identifying target interviewee who has unusual high contribution margin ratio then other companies in the same industry.
Contribution margin is also one of the factors to judge whether a company has monopoly power in competition law, such as use of the Lerner Index test.
Read more about this topic: Contribution Margin