Contributions in Accounting: 3 Meanings Defined
"What is a contribution in accounting?" is a complex question, as the answer changes depending on the context. "Contribution" may refer to the contribution margin used in financial analysis, owner investments in a business, or nonprofit donations.
Understanding each type of contribution is a must for accurate accounting, financial reporting, and sound decision-making. Your accountant will help you apply the relevant definitions of this term to your business strategically to maximize its short- and long-term financial health.
1. Contribution Margin
Contribution margin is the amount remaining when variable costs are subtracted from sales revenue. It’s used to find out how much revenue is available to cover fixed costs and contribute to profit. Contribution margins help businesses evaluate the profitability of specific products, customers, sales channels, or employee performance, depending on how costs are tracked.
A business’s contribution margin is a significant profitability measure as it's used to inform pricing strategy, decisions about products, and how to control costs. This empowers managers to focus business resources on what drives value and to drop products or services that dent profitability. Contribution margin should be used alongside other measures like gross profit and net profit to measure profitability at different stages of your operations.
Contribution Margin Types and How to Calculate Them
Contribution margin can be expressed as a figure or a percentage. The contribution margin per unit is expressed as a dollar amount per unit, while the contribution margin ratio is expressed as a percentage. The contribution margin formula you need is slightly different for each type.
How to Calculate Contribution Margin per Unit
Contribution Margin per Unit = Selling Price - Variable Cost per Unit
How to Calculate Contribution Margin Ratio
Contribution Margin Ratio = (Contribution Margin / Sales Revenue) x 100
Example: A product that sells for $100 with variable costs of $35 will have a contribution margin of $65, or 65%.
How to Record Contribution Margins
Contribution margin is typically calculated using data from accrual accounting (a type of financial accounting as opposed to cost accounting). This involves recognizing all costs related to revenues (and revenues themselves) in the same period. It's not a formal financial statement recognized under GAAP. However, it's widely used for internal decision-making.
Experts in small business accounting, like our teams in Jacksonville, Florida, and Spartanburg, South Carolina, will help your business calculate and interpret contribution margins to gain the most accurate outlook and make the most profitable decisions for your business.
When to Use Contribution Margin in Business
Businesses use their contribution margin to inform several important internal strategic business decisions. These include topics such as:
Pricing: The contribution margin is used to determine the minimum sales price of each product or service required to cover expenses and avoid losses. This figure, in turn, influences decisions like how much discount to offer during sales or price hikes.
Determining product profitability: Businesses compare the contribution margin ratio of different products. This helps them decide which products or services to push, modify, or discontinue.
Break-even analysis: The break-even analysis quantifies how many units a business must sell to cover its costs, or break even. This is calculated by dividing total fixed costs by the contribution per unit. It's helpful for setting targets for future periods.
Sales performance: Profitability often differs across sales channels, regions, or sales reps. Businesses will examine each segment's contribution margin to find out how they contribute to overall profitability. This helps them allocate resources to the most effective channels.
Effective budgeting: A business's overall contribution margin is a useful figure for budgeting and forecasting.
What’s the Difference Between Profit and Contribution Margin?
Profit takes into account total revenue minus all a business's expenses, while contribution margin only subtracts variable costs from revenue. The latter shows the margin left to cover fixed costs and generate profit.
In other words, the contribution margin is the difference between the selling price and total variable costs for different products or services. The difference goes towards fixed costs, then contributes to the business’s profits.
Conversely, net profit reflects the total earnings after all costs (including fixed, variable, interest, taxes, and depreciation) are deducted from revenue. Profits are then reinvested or paid out as dividends.
What’s a Good Contribution Margin Percentage?
What businesses consider a "good" contribution margin percentage will vary from industry to industry, and even from business to business. A higher contribution margin generally indicates more flexibility to cover fixed costs and achieve greater profitability.
For example, software companies tend to have much higher contribution margins than retail or manufacturing businesses. This is because their products are digital rather than physical, eliminating many of the variable costs associated with manufacturing physical products and making them exponentially cheaper per unit when sold at scale.
Effective contribution margin analysis empowers businesses to act on the data it offers to make decisions that will bolster their business going forward.
2. Owner Contributions
Owner contributions (or equity contributions) are the funds or assets a business owner invests in their own company. Greater investment results in more owner equity in the business. This is then reflected in the equity section as capital contributions on the balance sheet.
Let's imagine a new business owner who has left a tech company to set up on her own. She makes her first owner contribution when she moves $50,000 of her personal savings into her new business bank account. However, this isn't the only way she can make an owner contribution, as equity contributions aren't limited to cash. For example, donating or transferring equipment she already owns into her business would also be considered an owner contribution.
In a corporation, owner contributions include share purchases made by investors or founders.
Why Are Owner Contributions Important?
An owner's investment in their business is an important sign of commitment to making the business work and confidence in its future success. For many new businesses, owner contributions are the first port of call to provide funding for the new business before looking for outside investment. Owner contributions also strengthen the company's equity position, as more equity boosts investor confidence.
How Are Owner Contributions Recorded?
Owner contributions are recorded as increases in business assets and the owner’s personal equity in the business. When an owner makes a contribution, the corresponding asset account (e.g., cash or equipment) is debited. The owner’s capital account is also credited to reflect their increase in equity.
For example, take a business owner who invests $5,000 in their soap-making business. The business records a debit in the cash account and a credit to the owner’s capital for the same amount.
Their contribution will appear on the balance sheet as it changes the business’s total assets and owner equity. However, the contribution doesn’t impact the income statement, as a contribution isn’t considered revenue.
3. Contributions in Nonprofit Accounting
Contributions in nonprofit accounting refer to donations or in-kind gifts accepted by charitable organizations. These must be given voluntarily to support the organization’s mission. Nonprofit contributions aren't limited to donations from individual donors. They also include contributions made by foundations, corporations, or government agencies.
Contributions make up most of the revenue in nonprofit organizations. Accounting for them accurately an absolute must.
What Counts as a Nonprofit Contribution?
Nonprofit contributions come in many different shapes and forms. These include:
Monetary donations: Donations can be one-off contributions (for example, from a school fundraiser) or regular cash donations from a recurring donor.
Grants from charitable foundations: Grants are often awarded to fund specific projects that align with the donor's mission.
In-kind contributions: These are non-cash contributions that offer nonprofits invaluable resources aside from funds. They include professional services like legal or financial guidance, free use of facilities or equipment, or tangible goods like food or clothing.
How Are Contributions Recorded in Nonprofit Accounting?
Nonprofits follow FASB ASC 958, the accounting standard governing nonprofit financial reporting. Nonprofits record contributions as contribution revenue in the Net Assets section of their nonprofit balance sheet.
Nonprofit contributions must be recorded as restricted or unrestricted net assets, depending on what the donors stipulated the funds were for. Restricted funds refer to funds earmarked for specific purposes or funds with donor restrictions of any kind. Unrestricted funds are available for any use in the nonprofit. Proper classification is essential for accurate reporting and to maintain trust with donors.
Be aware that you must also record in-kind contributions. Determine their fair market value and keep all documents related to the calculation. This will help you maintain consistency in subsequent reporting periods.
Record in-kind donations in the period they were given. Using one will incur an associated expense in the period the item or service was used. Unused items should be recorded in an asset account and depreciated over time. Be aware that the IRS also requires nonprofit organizations to record the sale of in-kind contributions when they’re sold within three years of their donation via Form 8282.
There are various other stipulations for recording specific in-kind contributions, for example, if the donor has earmarked a donation for a specific purpose. Your accountant will be familiar with these obligations and help you keep your records clear and compliant.
Use Contributions to Strengthen Your Financial Strategy
Understanding the different meanings of "contribution" in accounting is essential for accurate reporting, making smarter financial decisions, and developing a stronger business strategy. Each type of contribution plays a crucial role, whether you're managing profit margins, tracking owner equity, or complying with nonprofit standards.
Recognizing the purpose and impact of each contribution type empowers businesses to allocate resources better and plan ahead. Working with an accounting professional will ensure you're interpreting and applying these concepts correctly in your small business.
