Contribution margin is widely used for numerous decisions, such as accepting special orders, break-even analysis, projecting profitability, and assessing changes and investments in operating improvements. It is a simple calculation: Price minus Variable Cost. It is often turned into a percentage by dividing by the Price, and is often generalized as Total Revenue minus Total Variable Cost.
The simplicity of the calculation masks a wide range of assumptions and information quality issues that can have significant impact for decision-making. Since most companies use traditional standard costing as their primary source of costing information, two areas merit significant caution when using contribution margin.
The first area of caution is ensuring that the nature of the decision and its impact on the company’s resources is fully reflected. Using contribution margin assumes you have identified all the variable resources that will incrementally change as a result of the decision being made. This has implications beyond manufacturing operations. For example, additional resources may be used for procuring more raw material, paying sales commissions and marketing expenses, or arranging deliveries, or for payroll/personnel actions or equipment maintenance. You also need to look for incremental changes to resources typically considered fixed costs. For example, is additional equipment or floor space being added, are new supervisors or managers being hired, or is software or IT equipment being added?
A final consideration that is often overlooked is the impact of idle and excess capacity. Managers should continually seek to create excess and idle capacity by becoming more efficient. However, traditional standard costing often buries that achievement. If excess capacity allows more production, the contribution margin could understate the financial benefit. Conversely, if it is assumed the additional work associated with the decision can be “absorbed” and it requires more resources, the contribution margin will overstate the financial benefit.
The second area of caution is ensuring that the costs used reflect the use of the organization’s resources. Traditional standard costing, many activity-based costing models, and the traditional definitions of fixed and variable cost relate all costs to the final product. A generalized cost driver is often used to allocate direct and indirect cost pools to the product. This has two main problems: It can make fixed costs look variable, or it can cause an analyst to evaluate an entire pool as fixed. Either outcome will distort the contribution margin information used to make a decision.
For a costing approach to accurately track fixed and variable cost in relation to a final product, it must track how costs change as they move from resource to resource through a process. This has been identified in the Institute of Management Accountant’s Conceptual Framework for Managerial Accounting as the concept of responsiveness. For example, electricity becomes a fixed cost when it is used to heat or cool a production facility that must be maintained at a constant temperature, even during an idle shift. Conversely, the cost of electricity to operate production machines is a variable cost. The framework suggests the word “proportional cost,” which means the cost varies with the output of a particular resource pool; only some resource pools produce final products. A second concept, called attributability, defines the need to apply changes in cost that have a fixed or weak causal relationship with final products that may impact a management decision.
When using contribution margin, manufacturers should ask: Does the financial information provided match the operations of the company? If the answer is no, examine the resources impacted and the costs used in the analysis for clear causal relationships that reflect the company’s processes, and consider the need for a new costing approach oriented toward decision-making rather than financial reporting.
>> Larry White, CMA, CFM, CPA, CGFM, [email protected], is the Executive Director of the Resource Consumption Accounting Institute (www.rcainstitute.org), which trains and advocates for improved cost information connected to operational business performance.