Contribution Definition of contribution Contribution is the difference
Contribution
Definition of contribution • Contribution is the difference between sales • • • revenue and variable cost It is the amount remaining after variable costs have been deducted from sales revenue Contribution is not the same as profit since we reach a figure for contribution we have only deducted variable costs and not fixed costs Total contribution equals sales revenue minus variable costs
Contribution per unit • As well as total contribution it is also useful to calculate the contribution that each unit of sales produces • Contribution per unit is revenue per unit (price) minus variable costs per unit
Contribution to what? • In the first instance it is contribution to fixed costs • Once fixed costs have been covered it is contribution to profits • Total contribution = total fixed costs + profit • Therefore, profit = total contribution minus total fixed costs
Strengths of the concept • It is useful in decision making • It avoids the need for arbitrary division of fixed costs • It provides a flexible basis for pricing decisions
Weaknesses of the concept • Ignores fixed costs • Some costs are difficult to classify as fixed or variable • In the longer term, fixed costs can change thus invalidating earlier decisions based on contribution
Marginal costing
Marginal costing • An accounting system in which variable costs are • • • charged to cost units and fixed costs of the period are written in full against aggregate contribution The valuation of a product solely on the basis of variable costs Fixed costs are excluded Marginal costing focuses on sales, variable costs and contribution Fixed costs are considered irrelevant for short run decisions because they are fixed regardless of the level of output within the relevant range Fixed costs are difficult to allocate especially in the case of multi-product firms
Marginal cost statements • Sales revenue • Less variable costs (direct labour, direct materials, variable production overheads, variable selling and distribution overheads) Equals contribution • Less total fixed costs (production overheads, selling overheads, distribution overheads, administrative expenses) Equals net profit before tax
So how is this different from absorption costing? • In absorption cost direct costs are distinguished from indirect costs • In marginal costing variable costs are distinguished from fixed costs • In absorption costing the indirect overhead costs are divided up and the burden of carrying them is shared amongst the various products made by the firm • In marginal costing there is no attempt to divide up the overheads
A marginal cost statement Product A Product B Product C Total 100 70 30 200 Less VC 60 40 10 110 Contribution 40 30 20 90 Sales Less FC 40 Profit 50
What is so special about it? • Fixed costs are not apportioned • They are not divided up between the three • • products This is because any sharing out of fixed costs is arbitrary and often unfair The contribution of each is identified Fixed costs are deducted from total contribution This focus on contribution is useful in short term decision-making
Arguments in favour of marginal costing • Marginal costing is simple to operate • There are no arbitrary fixed costs • • • apportionments Over/under absorption is avoided Absorption costing information is irrelevant when making short run decisions Fixed costs in a period will be the same irrespective of the level of output - therefore can be ignored for short-run decisions making
Advantages of marginal costing • Market based • Fixed cost are periodic and incurred • Covers all incremental • • costs Avoids arbitrary apportionment of fixed costs Avoids the problem of determining a suitable basis for overhead apportionment • irrespective of production levels Fixed costs may not be chargeable at departmental levels and should not be included in production costs
Disadvantages of marginal costing • Pricing at the margin may lead to under- pricing with too little contribution and nonrecovery of fixed costs, especially in a recession • Stock valuation does not comply with SSAP 9 as no element of fixed production costs is absorbed into stocks
Uses in decision making and planning • Marginal costing is called contribution analysis when used for decision making • It is useful in short term decision making: – Break even analysis – Special order contracts – Make or buy decision – Deletion of an unprofitable product
Break even analysis Introduction
Break even analysis • At the break even level of output total costs are covered by total revenue so that the firm makes neither profit or loss • Contribution can be used to calculate the break even point • Think of contribution per unit as the surplus over variable costs • How many units of “contribution” are needed to cover fixed costs?
Break even output • Break even is calculated by dividing fixed costs • by contribution per unit. Data: – – – Fixed costs £ 5 m Selling price £ 5 per unit Variable costs per unit £ 3 • Therefore contribution per unit : £ 5 - £ 3 = £ 2 • And break even occurs at £ 5 m divided £ 2 equals • • 2. 5 m units At output levels below 2. 5 m the firm makes a loss At output levels above 2. 5 m the firm will make a profit
Target profit • Suppose the firm wants to achieve a specific target level of profit from the product • What level of output and sales are needed to achieve the target profit? • Let us use the above example but impose a profit target of £ 5 m
Target profit • Fixed costs £ 5 m • Profit target £ 4 m • Total contribution required £ 5 m + £ 4 m = £ 9 m • Contribution per unit : £ 5 - £ 3 = £ 2 • Output and sales necessary to achieve the target profit: £ 9 m / £ 2 = 4. 9 m units
Special order contract (SOC)
Special order contract • Typically this involves a supplier receiving large order placed by a customer • The offer price exceeds variable costs but is insufficient to cover the full costs of production • As a result the contract is apparently unprofitable • Should the supplier accept the contract?
Example • Variable cost per unit : 100 p • Fixed costs per unit: 150 p at current output • Usual selling price: 300 p per unit • Current output: 500, 000 units • Full capacity output: 750, 000 units • Special order contract offer: 100, 000 units at a price of 140 p • Should the contract be accepted?
Reject it! • It is unprofitable • It will make a loss of 250 p -140 p =110 p • But this ignores some important points – Break even has already been achieved – The firm has spare capacity – The SOC does make a contribution
Break even • Fixed costs = £ 1. 5 x 500, 000 units = £ 750, 000 • Break even is fixed costs divided by contribution per unit • Contribution on regular orders is £ 3 - £ 1 • Therefore break even occurs at 750, 000 divided by 2 = 375, 000 units
Ignore fixed costs • We can ignore fixed costs as they have already • • • been covered The contribution from the SOC is 140 p - 100 p = 40 p per unit Each unit of the special order contract adds 40 p to profit The SOC will add 40 p x 100, 000 = £ 40, 000 to the firms profits This is additional profit which would not be received if the SOC is rejected Conclusion: accept the contract
Sunk costs • Costs which have either been paid for or are owed under a legally binding contract • As a result they are irrelevant to future decisions and should be ignored
Accept a special order contract if. . • Price exceeds variable costs per unit and • • • therefore makes a contribution The business has spare capacity The contract represents additional sales and not sales which displace regular work A more profitable contract is not available The product will not be resold at a higher price The supplier is not locked into a long term contract Accepting the order enables the firm to break
Make or buy-in?
Make or buy-in • A firm is faced with a decision: – Should it continue produce the component itself? • Or – Should it buy in the component from an outside firm? • It will depend on the relative costs
Make or buy-in: an example • Cost of making: 50 p per unit • Purchase price when buying in: 70 p per unit • Quantity required: 200, 000 units • Savings in terms of fixed costs when the components is bought in: £ 60, 000
The decision • The extra cost when buying in: • 70 p - 50 p = 20 p per unit • Over 200, 000 units this represents £ 40, 000 in lost contribution • But we have not yet taken into account the savings in terms of fixed costs • Buying in adds £ 40, 000 to variable costs but saves £ 60, 000 on fixed costs • It is advantageous to buy-in
Make or buy in: conclusion • If savings on fixed costs exceed the lost contribution when buying in at a higher price then it is worthwhile buying in • But there other factors to consider • The reliability of the supply firm • The quality of the bought in product • The loss of expertise • Will the new supplier raise price a future contract thus making buying in unprofitable?
Deletion of an unprofitable product
Deletion of the unprofitable profit • In this case we have a multi-product firm • Each product is a profit centre • For each product attributable costs are allocated • Overhead costs are apportioned in some way • As a result one product appears to be unprofitable and is clearly a candidate for deletion
Example £ 000 Sales Variable costs Fixed costs Profit (loss) Product A 50 Product B 80 Product C 90 Total 30 35 40 105 35 35 35 105 (I 5) 10 15 I 0 220
Delete product A? • As its sales revenue does not cover full costs it is • • loss making and should be dropped But this overlooks important points: A does make a positive contribution-this will be lost if A is dropped The equal apportionment of fixed costs is arbitrary and probably unfair to this product If A is dropped there is no guarantee than overheads will be reduced by £ 35, 000
Re-presenting the figures £ 000 Sales Variable costs Contribution Less fixed costs Profit Product A 50 Product B 80 Product C 90 Total 30 35 40 105 20 45 50 115 220 105 10
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