ContributionContribution

Definition of contribution Definition of contribution

• Contribution is the difference between sales Contribution is the difference between sales revenue and variable costrevenue and variable cost

• It is the amount remaining after variable costs It is the amount remaining after variable costs have been deducted from sales revenuehave been deducted from sales revenue

• Contribution is not the same as profit since we Contribution is not the same as profit since we reach a figure for contribution we have only reach a figure for contribution we have only deducted variable costs and not fixed costsdeducted variable costs and not fixed costs

• Total contribution equals sales revenue minus Total contribution equals sales revenue minus variable costsvariable costs

Contribution per unitContribution per unit

• As well as total contribution it is also As well as total contribution it is also useful to calculate the contribution useful to calculate the contribution that each unit of sales producesthat each unit of sales produces

• Contribution per unit is revenue per Contribution per unit is revenue per unit (price) minus variable costs per unit (price) minus variable costs per unitunit

Contribution to what?Contribution to what?

• In the first instance it is contribution In the first instance it is contribution to fixed coststo fixed costs

• Once fixed costs have been covered it Once fixed costs have been covered it is contribution to profitsis contribution to profits

• Total contribution = total fixed costs Total contribution = total fixed costs + profit+ profit

• Therefore, profit = total contribution Therefore, profit = total contribution minus total fixed costsminus total fixed costs

Strengths of the concept Strengths of the concept

• It is useful in decision makingIt is useful in decision making

• It avoids the need for arbitrary It avoids the need for arbitrary division of fixed costsdivision of fixed costs

• It provides a flexible basis for pricing It provides a flexible basis for pricing decisionsdecisions

Weaknesses of the conceptWeaknesses of the concept

• Ignores fixed costsIgnores fixed costs

• Some costs are difficult to classify as Some costs are difficult to classify as fixed or variablefixed or variable

• In the longer term, fixed costs can In the longer term, fixed costs can change thus invalidating earlier change thus invalidating earlier decisions based on contributiondecisions based on contribution

Marginal costingMarginal costing

Marginal costingMarginal costing

• An accounting system in which variable costs are An accounting system in which variable costs are charged to cost units and fixed costs of the period are charged to cost units and fixed costs of the period are written in full against aggregate contributionwritten in full against aggregate contribution

• The valuation of a product solely on the basis of The valuation of a product solely on the basis of variable costsvariable costs

• Fixed costs are excludedFixed costs are excluded• Marginal costing focuses on sales, variable costs and Marginal costing focuses on sales, variable costs and

contributioncontribution• Fixed costs are considered irrelevant for short run Fixed costs are considered irrelevant for short run

decisions because they are fixed regardless of the level decisions because they are fixed regardless of the level of output within the relevant rangeof output within the relevant range

• Fixed costs are difficult to allocate especially in the case Fixed costs are difficult to allocate especially in the case of multi-product firmsof multi-product firms

Marginal cost statementsMarginal cost statements

• Sales revenueSales revenue• Less variable costs (direct labour, direct Less variable costs (direct labour, direct

materials, variable production overheads, materials, variable production overheads, variable selling and distribution overheads)variable selling and distribution overheads)

Equals contributionEquals contribution• Less total fixed costs (production Less total fixed costs (production

overheads, selling overheads, distribution overheads, selling overheads, distribution overheads, administrative expenses)overheads, administrative expenses)

Equals net profit before taxEquals net profit before tax

So how is this different from So how is this different from absorption costing?absorption costing?

• In absorption cost direct costs are In absorption cost direct costs are distinguished from indirect costsdistinguished from indirect costs

• In marginal costing variable costs are In marginal costing variable costs are distinguished from fixed costsdistinguished from fixed costs

• In absorption costing the indirect overhead In absorption costing the indirect overhead costs are divided up and the burden of costs are divided up and the burden of carrying them is shared amongst the carrying them is shared amongst the various products made by the firmvarious products made by the firm

• In marginal costing there is no attempt to In marginal costing there is no attempt to divide up the overheadsdivide up the overheads

A marginal cost statement A marginal cost statement Product Product

AAProduct Product

BBProduct CProduct C Total Total

SalesSales 100100 7070 3030 200200

Less VCLess VC 6060 4040 1010 110110

ContributiContributionon

4040 3030 2020 9090

Less FCLess FC 4040

Profit Profit 5050

What is so special about it?What is so special about it?

• Fixed costs are not apportionedFixed costs are not apportioned

• They are not divided up between the three They are not divided up between the three productsproducts

• This is because any sharing out of fixed costs is This is because any sharing out of fixed costs is arbitrary and often unfairarbitrary and often unfair

• The contribution of each is identifiedThe contribution of each is identified

• Fixed costs are deducted from total contributionFixed costs are deducted from total contribution

• This focus on contribution is useful in short term This focus on contribution is useful in short term decision-makingdecision-making

Arguments in favour of Arguments in favour of marginal costingmarginal costing

• Marginal costing is simple to operateMarginal costing is simple to operate

• There are no arbitrary fixed costs There are no arbitrary fixed costs apportionmentsapportionments

• Over/under absorption is avoidedOver/under absorption is avoided

• Absorption costing information is irrelevant Absorption costing information is irrelevant when making short run decisionswhen making short run decisions

• Fixed costs in a period will be the same Fixed costs in a period will be the same irrespective of the level of output - therefore irrespective of the level of output - therefore can be ignored for short-run decisions makingcan be ignored for short-run decisions making

Advantages of marginal Advantages of marginal costing costing • Market basedMarket based• Covers all Covers all

incremental costsincremental costs• Avoids arbitrary Avoids arbitrary

apportionment of apportionment of fixed costsfixed costs

• Avoids the problem Avoids the problem of determining a of determining a suitable basis for suitable basis for overhead overhead apportionmentapportionment

• Fixed cost are Fixed cost are periodic and periodic and incurred incurred irrespective of irrespective of production levelsproduction levels

• Fixed costs may not Fixed costs may not be chargeable at be chargeable at departmental levels departmental levels and should not be and should not be included in included in production costs production costs

Disadvantages of marginal Disadvantages of marginal costingcosting

• Pricing at the margin may lead to Pricing at the margin may lead to under-pricing with too little under-pricing with too little contribution and non-recovery of contribution and non-recovery of fixed costs, especially in a recessionfixed costs, especially in a recession

• Stock valuation does not comply with Stock valuation does not comply with SSAP9 as no element of fixed SSAP9 as no element of fixed production costs is absorbed into production costs is absorbed into stocksstocks

Uses in decision making and Uses in decision making and planningplanning• Marginal costing is called contribution Marginal costing is called contribution

analysis when used for decision makinganalysis when used for decision making

• It is useful in short term decision It is useful in short term decision making:making:– Break even analysisBreak even analysis– Special order contractsSpecial order contracts– Make or buy decisionMake or buy decision– Deletion of an unprofitable productDeletion of an unprofitable product

Break even analysisBreak even analysisIntroductionIntroduction

Break even analysisBreak even analysis

• At the break even level of output total At the break even level of output total costs are covered by total revenue so that costs are covered by total revenue so that the firm makes neither profit or lossthe firm makes neither profit or loss

• Contribution can be used to calculate the Contribution can be used to calculate the break even pointbreak even point

• Think of contribution per unit as the Think of contribution per unit as the surplus over variable costssurplus over variable costs

• How many units of “contribution” are How many units of “contribution” are needed to cover fixed costs?needed to cover fixed costs?

Break even outputBreak even output

• Break even is calculated by dividing fixed costs Break even is calculated by dividing fixed costs by contribution per unit.by contribution per unit.

• Data:Data:– Fixed costs £5mFixed costs £5m– Selling price £5 per unitSelling price £5 per unit– Variable costs per unit £3Variable costs per unit £3

• Therefore contribution per unit :£5 - £3 = £2Therefore contribution per unit :£5 - £3 = £2• And break even occurs at £5m divided £2 equals And break even occurs at £5m divided £2 equals

2.5m units2.5m units• At output levels below 2.5m the firm makes a lossAt output levels below 2.5m the firm makes a loss• At output levels above 2.5m the firm will make a At output levels above 2.5m the firm will make a

profitprofit

Target profitTarget profit

• Suppose the firm wants to achieve a Suppose the firm wants to achieve a specific target level of profit from the specific target level of profit from the productproduct

• What level of output and sales are What level of output and sales are needed to achieve the target profit?needed to achieve the target profit?

• Let us use the above example but Let us use the above example but impose a profit target of £5mimpose a profit target of £5m

Target profitTarget profit

• Fixed costs £5mFixed costs £5m

• Profit target £4mProfit target £4m

• Total contribution required £5m + Total contribution required £5m + £4m = £9m£4m = £9m

• Contribution per unit :£5 - £3 = £2Contribution per unit :£5 - £3 = £2

• Output and sales necessary to Output and sales necessary to achieve the target profit: £9m / £2 = achieve the target profit: £9m / £2 = 4.9m units4.9m units

Special order contract Special order contract (SOC)(SOC)

Special order contract Special order contract

• Typically this involves a supplier receiving Typically this involves a supplier receiving large order placed by a customerlarge order placed by a customer

• The offer price exceeds variable costs but The offer price exceeds variable costs but is insufficient to cover the full costs of is insufficient to cover the full costs of productionproduction

• As a result the contract is apparently As a result the contract is apparently unprofitableunprofitable

• Should the supplier accept the contract?Should the supplier accept the contract?

Example Example

• Variable cost per unit :100pVariable cost per unit :100p

• Fixed costs per unit: 150p at current outputFixed costs per unit: 150p at current output

• Usual selling price: 300p per unitUsual selling price: 300p per unit

• Current output: 500,000 unitsCurrent output: 500,000 units

• Full capacity output: 750,000 unitsFull capacity output: 750,000 units

• Special order contract offer: 100,000 units Special order contract offer: 100,000 units at a price of 140pat a price of 140p

• Should the contract be accepted?Should the contract be accepted?

Reject it!Reject it!

• It is unprofitableIt is unprofitable

• It will make a loss of 250p -140p It will make a loss of 250p -140p =110p=110p

• But this ignores some important But this ignores some important pointspoints– Break even has already been achievedBreak even has already been achieved– The firm has spare capacityThe firm has spare capacity– The SOC does make a contributionThe SOC does make a contribution

Break evenBreak even

• Fixed costs = £1.5 x 500,000 units = Fixed costs = £1.5 x 500,000 units = £750,000£750,000

• Break even is fixed costs divided by Break even is fixed costs divided by contribution per unitcontribution per unit

• Contribution on regular orders is £3 - £1Contribution on regular orders is £3 - £1

• Therefore break even occurs at 750,000 Therefore break even occurs at 750,000 divided by 2 = 375,000 unitsdivided by 2 = 375,000 units

Ignore fixed costsIgnore fixed costs

• We can ignore fixed costs as they have already We can ignore fixed costs as they have already been coveredbeen covered

• The contribution from the SOC is 140p - 100p = The contribution from the SOC is 140p - 100p = 40p per unit40p per unit

• Each unit of the special order contract adds 40p Each unit of the special order contract adds 40p to profitto profit

• The SOC will add 40p x 100,000 = £40,000 to The SOC will add 40p x 100,000 = £40,000 to the firms profitsthe firms profits

• This is additional profit which would not be This is additional profit which would not be received if the SOC is rejectedreceived if the SOC is rejected

• Conclusion: accept the contract Conclusion: accept the contract

Sunk costsSunk costs

• Costs which have either been paid Costs which have either been paid for or are owed under a legally for or are owed under a legally binding contractbinding contract

• As a result they are irrelevant to As a result they are irrelevant to future decisions and should be future decisions and should be ignoredignored

Accept a special order Accept a special order contract if..contract if..• Price exceeds variable costs per unit and therefore Price exceeds variable costs per unit and therefore

makes a contributionmakes a contribution

• The business has spare capacityThe business has spare capacity

• The contract represents additional sales and not The contract represents additional sales and not sales which displace regular worksales which displace regular work

• A more profitable contract is not availableA more profitable contract is not available

• The product will not be resold at a higher priceThe product will not be resold at a higher price

• The supplier is not locked into a long term contractThe supplier is not locked into a long term contract

• Accepting the order enables the firm to break into Accepting the order enables the firm to break into new marketsnew markets

Make or buy-in?Make or buy-in?

Make or buy-inMake or buy-in

• A firm is faced with a decision:A firm is faced with a decision:– Should it continue produce the Should it continue produce the

component itself?component itself?

• OrOr– Should it buy in the component from an Should it buy in the component from an

outside firm?outside firm?

• It will depend on the relative costsIt will depend on the relative costs

Make or buy-in: an exampleMake or buy-in: an example

• Cost of making: 50p per unitCost of making: 50p per unit

• Purchase price when buying in:70p Purchase price when buying in:70p per unitper unit

• Quantity required: 200,000 unitsQuantity required: 200,000 units

• Savings in terms of fixed costs when Savings in terms of fixed costs when the components is bought in: the components is bought in: £60,000£60,000

The decision The decision

• The extra cost when buying in:The extra cost when buying in:• 70p - 50p = 20p per unit70p - 50p = 20p per unit• Over 200,000 units this represents Over 200,000 units this represents

£40,000 in lost contribution£40,000 in lost contribution• But we have not yet taken into account But we have not yet taken into account

the savings in terms of fixed coststhe savings in terms of fixed costs• Buying in adds £40,000 to variable costs Buying in adds £40,000 to variable costs

but saves £60,000 on fixed costsbut saves £60,000 on fixed costs• It is advantageous to buy-inIt is advantageous to buy-in

Make or buy in: conclusionMake or buy in: conclusion

• If savings on fixed costs exceed the lost If savings on fixed costs exceed the lost contribution when buying in at a higher contribution when buying in at a higher price then it is worthwhile buying inprice then it is worthwhile buying in

• But there other factors to considerBut there other factors to consider• The reliability of the supply firmThe reliability of the supply firm• The quality of the bought in productThe quality of the bought in product• The loss of expertiseThe loss of expertise• Will the new supplier raise price a future Will the new supplier raise price a future

contract thus making buying in contract thus making buying in unprofitable?unprofitable?

Deletion of an unprofitable Deletion of an unprofitable productproduct

Deletion of the unprofitable Deletion of the unprofitable profitprofit

• In this case we have a multi-product firmIn this case we have a multi-product firm• Each product is a profit centreEach product is a profit centre• For each product attributable costs are For each product attributable costs are

allocatedallocated• Overhead costs are apportioned in some Overhead costs are apportioned in some

wayway• As a result one product appears to be As a result one product appears to be

unprofitable and is clearly a candidate unprofitable and is clearly a candidate for deletionfor deletion

Example Example £000£000 Product Product

A AProduct Product

B BProduct Product

CCTotalTotal

Sales Sales 5050 8080 9090 220220

Variable Variable costscosts

3030 3535 4040 105105

Fixed Fixed costscosts

3535 3535 3535 105105

Profit Profit (loss)(loss)

(I5)(I5) 1010 15 15 I0I0

Delete product A?Delete product A?

• As its sales revenue does not cover full costs As its sales revenue does not cover full costs it is loss making and should be droppedit is loss making and should be dropped

• But this overlooks important points:But this overlooks important points:

• A does make a positive contribution-this will A does make a positive contribution-this will be lost if A is droppedbe lost if A is dropped

• The equal apportionment of fixed costs is The equal apportionment of fixed costs is arbitrary and probably unfair to this productarbitrary and probably unfair to this product

• If A is dropped there is no guarantee than If A is dropped there is no guarantee than overheads will be reduced by £35,000overheads will be reduced by £35,000

Re-presenting the figuresRe-presenting the figures£000£000 ProductProduct

AAProductProduct

B B ProductProduct

CCTotal Total

Sales Sales 5050 8080 9090 220220

Variable Variable costscosts

3030 3535 4040 105105

ContributioContributionn

2020 4545 5050 115115

Less fixed Less fixed costscosts

105105

Profit Profit 1010