Contribution approach definition
/What is the Contribution Approach?
The contribution approach is a presentation format used for the income statement, where all variable costs are aggregated and deducted from revenue in order to arrive at a contribution margin, after which all fixed costs are deducted from the contribution margin in order to arrive at the net profit or loss. The format of an income statement under the contribution approach is as follows:
| + | Revenue |
| - | Variable production expenses (such as materials, supplies, and variable overhead) |
| - | Variable selling and administrative expenses |
| = | Contribution margin |
| - | Fixed production expenses (including most overhead) |
| - | Fixed selling and administrative expenses |
| = | Net profit or loss |
The contribution approach is not normally used for the presentation of financial results, since standard usage instead requires a presentation where manufacturing costs are deducted from revenue in order to arrive at a gross margin, after which all selling, general and administrative expenses are deducted from the gross margin in order to arrive at the net profit or loss.
Both methods yield the same bottom line profit or loss information, but reveal different types of information while doing so. The contribution approach presents fixed and variable cost information, which is useful for breakeven analysis, while the traditional approach presents department information, which can be more useful when assigning costs to areas of responsibility.
Advantages of the Contribution Approach
The main advantage of the contribution approach is that it clearly identifies and segregates all variable expenses in one place. This makes it much easier to conduct an accurate breakeven analysis that can clearly identify the breakeven sales level of a business.
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The Difference Between the Contribution Approach and Traditional Approach
The key difference in income statement presentation between the contribution approach and the traditional approach is that the contribution approach shifts all fixed production costs further down in the income statement. Also, if there are any variable expenses among the selling and administrative expenses (such as commissions), they are moved up in the income statement, where they are included in the calculation of the contribution margin.
Whichever presentation approach is used, a company should be consistent in using the same form of presentation for all periods included in the financial statements.
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