What is Contribution?

Contribution is the amount of earnings remaining after all direct costs have been subtracted from revenue. This remainder is the amount available to pay for any fixed costs that a business incurs during a reporting period. Any excess of contribution over fixed costs equals the profit earned.

Direct costs are any costs that vary directly with revenues, such as the cost of materials and commissions. For example, if a business has revenues of $1,000 and direct costs of $800, then it has a residual amount of $200 that can be contributed to the payment of fixed costs. This $200 amount is the contribution arising from operations.

The contribution concept is usually referred to as contribution margin, which is the residual amount divided by revenues. It is easier to evaluate contribution on a percentage basis, to see if there are changes in the proportion of contribution to revenues over time.

Contribution should be calculated using the accrual basis of accounting, so that all costs related to revenues are recognized in the same period as the revenues. Otherwise, the amount of expense recognized may incorrectly include costs not related to revenues, or not include costs that should be related to revenues.

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When to Measure Contribution

Here are a number of situations in which it makes sense to measure contribution:

Evaluating product profitability. Measuring contribution helps businesses assess which products are most profitable by showing how much each product contributes to covering fixed costs and generating profit. By comparing the contribution margins of different products, managers can make informed decisions about which items to promote, modify, or discontinue.
Pricing decisions. Contribution analysis aids in setting prices by revealing how much each sale contributes to covering fixed costs and profit. Businesses can use this information to determine the minimum price needed to avoid losses and to evaluate the impact of discounts or price increases on profitability.
Break-even analysis. Understanding contribution is essential for break-even analysis, which identifies the sales volume required to cover all costs. By dividing total fixed costs by the contribution per unit, companies can determine how many units they need to sell to start making a profit, helping them set realistic sales targets.
Product mix optimization. When resources such as production capacity or labor are limited, measuring contribution helps in deciding the optimal product mix. Businesses can prioritize products with higher contribution margins to maximize overall profitability within the constraints of available resources.
Assessing sales performance. Contribution analysis provides insight into the profitability of different sales channels, regions, or sales representatives. By examining how much each segment contributes after direct costs, companies can allocate resources more effectively and focus efforts on the most profitable areas.
Capital expenditure analysis. Management can estimate how expenditures for fixed assets alter the amount of direct costs incurred, and how this impacts profits. For example, an expenditure for a robot can reduce direct labor costs, but increases fixed costs.
Budget formulation. The management team can use estimates of sales, direct costs, and fixed costs to forecast profit levels in future periods. This is especially useful when a business has a large fixed cost base, and so requires substantial sales volume just to break even.