A contribution format income statement, also known as a "contribution margin income statement", separates a business's costs into variable costs and fixed costs. A variable cost changes with the amount of production, while a fixed cost stays constant regardless of the amount of production. Contribution income statements are typically only used for internal business purposes and are not usually disclosed to investors or other outside agencies.
The "contribution margin" is the difference between total sales and variable costs. Variable costs can include production expenses, such as materials, supplies and overhead, as well as variable selling and administrative expenses, such as sales commissions and distribution costs. The contribution margin measures the contribution of the sales efforts toward the company's profits, without regard for fixed costs, taxes or other costs not directly related to sales. For instance, if XYZ Widgets Inc. had $500,000 in annual sales and $200,000 in variable costs, its contribution margin would be $300,000.
The "total income before tax" line on the contribution format income statement is the difference between the contribution margin and fixed costs. Fixed costs are costs that do not change relative to the amount of production. Rent, utilities, payroll and other administrative expenses not related to sales or production are considered fixed costs. In the case of XYZ Widgets Inc., a contribution margin of $300,000 and annual fixed costs of $100,000 would give a total income before tax of $200,000.
The contribution format income statement calculates net income by subtracting estimated taxes from total income before tax. The estimated tax amount comes from using an effective tax rate. An effective tax rate is a rate used if the company applied the same tax rate consistently over the accounting period. If XYZ Widgets Inc. used an effective tax rate of 20 percent, its tax expense would be 20 percent of $200,000, or $40,000, leaving a net income after taxes of $160,000.
While the conventional income statement has its uses for external reporting functions, it is not as effective when used for internal reporting purposes. Traditional income statements do not differentiate between fixed and variable costs. The cost breakdowns shown in the contribution format income statements enable managers to see where they can control costs, make more-effective plans and reach critical decisions. For instance, XYZ Widgets Inc. can use the contribution format income statement to determine if most of their costs come from fixed or variable sources and how to reduce those costs.