I posted yesterday about short term decision making processes and while writing the post noticed that I hadn’t talked about one of the key accounting concepts related to many of the decision formats: contribution margin.
First I need to back up even further.
On a normal income or revenue statement there are two types of costs: cost of goods sold (COGS) and administrative and other costs (sometimes called SG&A or Selling, General and Administrative costs). COGS can be thought of as how much it cost to make or buy what you’re selling. For a retailer it may just be the wholesale price. For a manufacturer or a service provider it includes all kinds of costs that lead up to producing a finished good that goes out the door.
The problem is that for most management decisions the COGS vs. SG&A isn’t the best framework for examining costs and benefits because there are some costs that change with the quantity of a good produced and sold (a variable cost) and some costs that just don’t (fixed costs). Additionally there are some costs that have mixed properties…meaning they’re part fixed and part variable.
In a manufacturing context variable costs would include things like direct labor to produce the product and the direct materials that are a part of it. If you make one chair, you use a certain amount of wood. Two chairs, twice as much. Three chairs…you get the point.
Fixed costs would be things like rent, property taxes, the CEO salary. Fixed costs do not change within a relevant range. At some point a fixed cost has to increase when capacity is reached, but they jump in big increments, not based on the quantity of goods sold.
Mixed costs are things like utilities. They vary with usage, but they never drop to zero, even if production does.
So back to contribution margin. Contribution margin (CM) processes the income statement based on variable costs and fixed costs instead of COGS and SG&A. So a normal (simple form( income statement would be this:Sales -COGS Gross Profit -SG&A Net Income
Where as in CM format you’d find:Sales -Variable Costs (VC) Contribution Margin -Fixed Costs Net Income
All of the numbers add up the same, but it gives you an understanding of where the fixed costs are and where the variable costs are, so that you know where the problems are in profitability and how to address them. Hopefully that sheds some light on the processes from yesterday’s post!