Contribution Analysis – Importance, Uses,

Calculation and More

Contribution Analysis is useful in understanding the effect of direct and variable cost 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.

Table of Contents
1. Importance
2. Contribution Margin Calculation
3. Uses of Contribution Analysis
1. Arriving at Minimum Selling Price of a Product
2. Profit Volume Chart
3. Calculation of Break Even
4. Asses Losses
4. Advantages of Contribution Analysis
1. Ease of Use
2. Contingency Analysis
5. Disadvantage
6. Another Approach
7. Steps for Contribution Analysis

Importance
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
percentage. 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.

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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 budgeting process and
management accountant functions. Below are the various use cases of the contribution analysis;

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Arriving at Minimum Selling Price of a Product
 Companies always look for setting 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.

Asses Losses
 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 2501th unit.

In case, the company has set a target of selling of 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 their performance.
Contribution analysis alone helps in understanding some of the most critical points in profit.

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Contingency Analysis
 When calculating the margin of safety, a manager is doing contingency analysis. To be aware of
an exact number of units to be sold to stay above the margin of safety is beneficial for the
company.

Disadvantage
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 in this approach. To
overcome this, managers can make the guesstimates, but it depends on the personal capacity of
the manager to access the situation.

Another Approach
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 to production cost, revenue or a
company, rather to any program, be it a social cause, a political campaign, economic analysis
and more.

Under such an approach, a contribution analysis helps managers, researchers, and policymakers
to understand the contribution of their program to a particular outcome. Such an analysis,
therefore, 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

A few steps help to come up with a contribution analysis. Such steps can prove useful in both the
approaches of contribution analysis. These steps are:

1. Set out the problem that you need to find a solution for.
2. Develop the process, factors involved.
3. Gather data on the factors and parameters.
4. Analyze the performance based on data.
5. Make sure you do not miss anything. If you miss any data, then add it and analyze the
performance again.
6. Keep revising the data from time to time to ensure it remains effective.

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A point to note is that the contribution analysis is not a conclusion in itself. Rather, it offers
evidence and reasoning, which one can use to arrive at a meaningful conclusion.