Vibuthi mahatmyam is written in numerous chapters after chapters in sivapuranam, skaandam, and other saivite treatises . It is holy...because it is what is left after the ultimate test, the test by fire. You put any valuable thing, solid or liquid and at the optimum ignition point all possible materials are turned into gases. Whether gold or dirt put to fire--(even put to fire the dead body of human or any living being), all that remains is the ashes. Ashes are the viboothi. Lord siva is the presiding deity of the end of everything and after ensuring everything is burned off he smears the remining thing namely the ashes all over his body and perfrom tandavam. It is the viboothi or the holy meritorious remnant left behind by the Lord of Lords Sri Parameswara. Whatever may be your state of purity, when the vibuthi is smeared on the body you become pure because of the grace of Lord Siva. It is said that once sage Durvasas visited the hell at the invitation of Yama and he saw the dead beings incarcerated in fire,acid,alkali, dirt etc and there was misery everywhere. Out of curiosity he just peeped into a well where some such souls were suffering. The ashes from his face just fell into the well and immediately the sinful beings were liberated. The yogis and rishis use the holy ashes for curing all physical mental and moral diseases. The ashes we use are usually made of the dung of cow which is mixed with cow urine and the pieces of cow dung properly dried are put to fire on Sivarathri and after burning in its own contents, it turns into ashes. Thereafter the ashes are precipitated by keeping the mixture in water and the dessicated ash is the basic viboothi or bhasma. The burning process is performed uttering the panchakshara manthram throughout. Namah Sivaya.
This question has been answered many times by many but I repeat it because it is the service to Lord Siva