Contribution & Marginal Costing
After studying this section you should be able to:
- calculate contribution, break-even and margin of safety
- apply this to decision-making using marginal costing principles
Contribution
Contribution is the total revenue – variable costs
It measures how much is being contributed the fixed costs by the units that have been sold
Contribution – Fixed costs = Profit
Can calculate contribution per unit or contribution for all units of output
Marginal costing and decision-making
We know from AS that the difference between unit selling price and unit variable cost is the contribution made by the individual product towards the firm’s fixed costs. When enough individual contributions have been made, the firm’s total costs will be covered and it is at break-even point, making neither a profit nor a loss.
Contribution analysis therefore divides costs into their fixed and variable elements. Traditional absorption costing takes all costs into account when making decisions. A marginal costing approach can be used in decision-making, based on the argument that factors having no bearing on a decision are ignored. In this context, we ignore fixed costs on the argument that:
- they have to be paid regardless of income
- the apportionment of these fixed costs between different product lines is often arbitrary.
Discontinuing products
Another area of decision-making involves whether to discontinue an apparently unprofitable product or line. For example:
A company makes three products, A, B and C. Costs are split one-third fixed and two-thirds variable. Figures are:
| A | B | C | Total | |
| Sales (£000) | 32 | 50 | 45 | 127 |
| Total costs (£000) | 36 | 39 | 33 | 108 |
| Profit/(loss) | (4) | 11 | 12 | 19 |
Should product A be dropped?
Apparently, the overall profit of £19 000 masks a loss of £4000 for product A. Since fixed costs are apportioned without certainty, we can remove them from the calculations and display the information as a marginal costing statement:
| A | B | C | Total | |
| Sales | 32 | 50 | 45 | 127 |
| Variable costs | 24 | 26 | 22 | 72 |
| Contribution | 8 | 24 | 23 | 55 |
| Less fixed costs | 36 | |||
| Profit | 19 |
Total profit remains the same, but by calculating individual product contributions we can see that each product makes a contribution towards total fixed costs. On this argument, therefore, product A should be retained.
KEY POINT - Marginal costing approaches take account of contribution made towards total fixed costs, and avoid the arbitrary apportionment of fixed (indirect) costs to individual products.
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