What is a contribution income statement?

The contribution income statement is an income statement that groups line items by behavior (variable versus fixed) rather than inventoriability (manufacturing versus period) to highlight the contribution margin instead of the gross margin.

The contribution margin (\(CM_p\)) is the revenues (proportional to the units sold) minus the variable costs (also assumed proportional to the units qold). This amount is contributing towards covering first fixed costs and then generating profits for the period.

\[ \begin{aligned} CM_p & = R_p - Q_p \times V_c \\ & = R_p - VC_p \end{aligned} \]

You might remember from the second chapter about costing the typical structure of a financial income statement, i.e. the income statement used for financial reporting. It is represented in red hereafter, and it drastically differs from the structure of the contribution income statement which is here represented in blue:

\[ \begin{aligned} \color{red}{\textbf{Financial Income Statement }} \quad & \neq \quad \color{blue}{\textbf{ Contribution Income Statement}} \\ \\ \color{red}{\textbf{Revenues }} \quad & = \quad \color{blue}{\textbf{ Revenues}} \\ \color{red}{\textit{(Cost Of Goods Sold) }} \quad & \neq \quad \color{blue}{\textit{ (Variable Costs)}} \\ \color{red}{\textbf{Gross Margin }} \quad & \neq \quad \color{blue}{\textbf{ Contribution Margin}} \\ \color{red}{\textit{(Period Costs) }} \quad & \neq \quad \color{blue}{\textit{ (Fixed Costs)}} \\ \color{red}{\textbf{Operating Income }} \quad & = \quad \color{blue}{\textbf{ Operating Income}} \end{aligned} \]

You may also remember that under absorption costing (which is mandatory for financial reporting), the COGS gather both variable (e.g. raw materials consumed) and fixed (e.g. depreciation of the manufacturing equipment) costs. The costs you assigned to products which went through the inventory and then in the COGS are thus mixed. Moreover, period costs are mixed costs as well: they gather both variable (e.g. the sales commissions) and fixed (e.g. the rent of administrative offices) costs. Therefore, to conduct our analyses, we need to separate variable and fixed components and reorganize them into a contribution income statement:

The preceding diagram highlights a few important ideas. First, if we are given financial income statements, we have to separate fixed and variable components of costs (with a cost estimation technique). Second, while revenues and Operating Income are the same in both income statements (because we assume that all units produced are sold) the gross margin is not the contribution margin. Third, the contribution income statement reveals the underlying cost structure. Companies with a more variable cost structure will show a bigger block of costs above the contribution margin; companies with fixed costs structure will have a bigger block of costs below the contribution margin.

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