1. Contribution

2. Definition of contribution Contribution is the difference between sales revenue and variable cost Contribution is the difference between sales revenue and variable cost It is the amount remaining after variable costs have been deducted from sales revenue 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 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 Total contribution equals sales revenue minus variable costs

3. Contribution per unit As well as total contribution it is also useful to calculate the contribution that each unit of sales produces 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 per unit is revenue per unit (price) minus variable costs per unit

4. Contribution to what? In the first instance it is contribution to fixed costs In the first instance it is contribution to fixed costs Once fixed costs have been covered it is contribution to profits Once fixed costs have been covered it is contribution to profits Total contribution = total fixed costs + profit Total contribution = total fixed costs + profit Therefore, profit = total contribution minus total fixed costs Therefore, profit = total contribution minus total fixed costs

5. Strengths of the concept It is useful in decision making It is useful in decision making It avoids the need for arbitrary division of fixed costs It avoids the need for arbitrary division of fixed costs It provides a flexible basis for pricing decisions It provides a flexible basis for pricing decisions

6. Weaknesses of the concept Ignores fixed costs Ignores fixed costs Some costs are difficult to classify as fixed or variable 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 In the longer term, fixed costs can change thus invalidating earlier decisions based on contribution

7. Marginal costing

8. 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 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 The valuation of a product solely on the basis of variable costs Fixed costs are excluded Fixed costs are excluded Marginal costing focuses on sales, variable costs and contribution 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 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 Fixed costs are difficult to allocate especially in the case of multi-product firms

9. Marginal cost statements Sales revenue Sales revenue Less variable costs (direct labour, direct materials, variable production overheads, variable selling and distribution overheads) 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) Less total fixed costs (production overheads, selling overheads, distribution overheads, administrative expenses) Equals net profit before tax

10. So how is this different from absorption costing? In absorption cost direct costs are distinguished from indirect costs In absorption cost direct costs are distinguished from indirect costs In marginal costing variable costs are distinguished from fixed 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 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 In marginal costing there is no attempt to divide up the overheads

11. A marginal cost statement Product A Product B Product C Total Sales10070 30 30200 Less VC 60 6040 10 10110 Contribution 40 4030 20 2090 Less FC 40 Profit50

12. What is so special about it? Fixed costs are not apportioned Fixed costs are not apportioned They are not divided up between the three products They are not divided up between the three products This is because any sharing out of fixed costs is arbitrary and often unfair This is because any sharing out of fixed costs is arbitrary and often unfair The contribution of each is identified The contribution of each is identified Fixed costs are deducted from total contribution Fixed costs are deducted from total contribution This focus on contribution is useful in short term decision-making This focus on contribution is useful in short term decision-making

13. Arguments in favour of marginal costing Marginal costing is simple to operate Marginal costing is simple to operate There are no arbitrary fixed costs apportionments There are no arbitrary fixed costs apportionments Over/under absorption is avoided Over/under absorption is avoided Absorption costing information is irrelevant when making short run decisions 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 Fixed costs in a period will be the same irrespective of the level of output - therefore can be ignored for short-run decisions making

14. Advantages of marginal costing Market based Market based Covers all incremental costs Covers all incremental costs Avoids arbitrary apportionment of fixed costs Avoids arbitrary apportionment of fixed costs Avoids the problem of determining a suitable basis for overhead apportionment Avoids the problem of determining a suitable basis for overhead apportionment Fixed cost are periodic and incurred irrespective of production levels Fixed cost are periodic and incurred irrespective of production levels Fixed costs may not be chargeable at departmental levels and should not be included in production costs Fixed costs may not be chargeable at departmental levels and should not be included in production costs

15. Disadvantages of marginal costing Pricing at the margin may lead to under- pricing with too little contribution and non- recovery of fixed costs, especially in a recession Pricing at the margin may lead to under- pricing with too little contribution and non- recovery of fixed costs, especially in a recession Stock valuation does not comply with SSAP9 as no element of fixed production costs is absorbed into stocks Stock valuation does not comply with SSAP9 as no element of fixed production costs is absorbed into stocks

16. Uses in decision making and planning Marginal costing is called contribution analysis when used for decision making Marginal costing is called contribution analysis when used for decision making It is useful in short term 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

17. Break even analysis Introduction

18. 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 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 Contribution can be used to calculate the break even point Think of contribution per unit as the surplus over variable costs Think of contribution per unit as the surplus over variable costs How many units of “contribution” are needed to cover fixed costs? How many units of “contribution” are needed to cover fixed costs?

19. Break even output Break even is calculated by dividing fixed costs by contribution per unit. Break even is calculated by dividing fixed costs by contribution per unit. Data: Data: –Fixed costs £5m –Selling price £5 per unit –Variable costs per unit £3 Therefore contribution per unit :£5 - £3 = £2 Therefore contribution per unit :£5 - £3 = £2 And break even occurs at £5m divided £2 equals 2.5m units And break even occurs at £5m divided £2 equals 2.5m units At output levels below 2.5m the firm makes a loss At output levels below 2.5m the firm makes a loss At output levels above 2.5m the firm will make a profit At output levels above 2.5m the firm will make a profit

20. Target profit Suppose the firm wants to achieve a specific target level of profit from the product 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? 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 £5m Let us use the above example but impose a profit target of £5m

21. Target profit Fixed costs £5m Fixed costs £5m Profit target £4m Profit target £4m Total contribution required £5m + £4m = £9m Total contribution required £5m + £4m = £9m Contribution per unit :£5 - £3 = £2 Contribution per unit :£5 - £3 = £2 Output and sales necessary to achieve the target profit: £9m / £2 = 4.9m units Output and sales necessary to achieve the target profit: £9m / £2 = 4.9m units

22. Special order contract (SOC)

23. Special order contract Typically this involves a supplier receiving large order placed by a customer 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 The offer price exceeds variable costs but is insufficient to cover the full costs of production As a result the contract is apparently unprofitable As a result the contract is apparently unprofitable Should the supplier accept the contract? Should the supplier accept the contract?

24. Example Variable cost per unit :100p Variable cost per unit :100p Fixed costs per unit: 150p at current output Fixed costs per unit: 150p at current output Usual selling price: 300p per unit Usual selling price: 300p per unit Current output: 500,000 units Current output: 500,000 units Full capacity output: 750,000 units Full capacity output: 750,000 units Special order contract offer: 100,000 units at a price of 140p Special order contract offer: 100,000 units at a price of 140p Should the contract be accepted? Should the contract be accepted?

25. Reject it! It is unprofitable It is unprofitable It will make a loss of 250p -140p =110p It will make a loss of 250p -140p =110p But this ignores some important points But this ignores some important points –Break even has already been achieved –The firm has spare capacity –The SOC does make a contribution

26. Break even Fixed costs = £1.5 x 500,000 units = £750,000 Fixed costs = £1.5 x 500,000 units = £750,000 Break even is fixed costs divided by contribution per unit Break even is fixed costs divided by contribution per unit Contribution on regular orders is £3 - £1 Contribution on regular orders is £3 - £1 Therefore break even occurs at 750,000 divided by 2 = 375,000 units Therefore break even occurs at 750,000 divided by 2 = 375,000 units

27. Ignore fixed costs We can ignore fixed costs as they have already been covered We can ignore fixed costs as they have already been covered The contribution from the SOC is 140p - 100p = 40p per unit The contribution from the SOC is 140p - 100p = 40p per unit Each unit of the special order contract adds 40p to profit Each unit of the special order contract adds 40p to profit The SOC will add 40p x 100,000 = £40,000 to the firms profits The SOC will add 40p x 100,000 = £40,000 to the firms profits This is additional profit which would not be received if the SOC is rejected This is additional profit which would not be received if the SOC is rejected Conclusion: accept the contract Conclusion: accept the contract

28. Sunk costs Costs which have either been paid for or are owed under a legally binding contract 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 As a result they are irrelevant to future decisions and should be ignored

29. Accept a special order contract if.. Price exceeds variable costs per unit and therefore makes a contribution Price exceeds variable costs per unit and therefore makes a contribution The business has spare capacity The business has spare capacity The contract represents additional sales and not sales which displace regular work The contract represents additional sales and not sales which displace regular work A more profitable contract is not available A more profitable contract is not available The product will not be resold at a higher price The product will not be resold at a higher price The supplier is not locked into a long term contract The supplier is not locked into a long term contract Accepting the order enables the firm to break into new markets Accepting the order enables the firm to break into new markets

30. Make or buy-in?

31. Make or buy-in A firm is faced with a decision: A firm is faced with a decision: –Should it continue produce the component itself? Or Or – Should it buy in the component from an outside firm? It will depend on the relative costs It will depend on the relative costs

32. Make or buy-in: an example Cost of making: 50p per unit Cost of making: 50p per unit Purchase price when buying in:70p per unit Purchase price when buying in:70p per unit Quantity required: 200,000 units Quantity required: 200,000 units Savings in terms of fixed costs when the components is bought in: £60,000 Savings in terms of fixed costs when the components is bought in: £60,000

33. The decision The extra cost when buying in: The extra cost when buying in: 70p - 50p = 20p per unit 70p - 50p = 20p per unit Over 200,000 units this represents £40,000 in lost contribution 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 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 Buying in adds £40,000 to variable costs but saves £60,000 on fixed costs It is advantageous to buy-in It is advantageous to buy-in

34. 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 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 But there other factors to consider The reliability of the supply firm The reliability of the supply firm The quality of the bought in product The quality of the bought in product The loss of expertise The loss of expertise Will the new supplier raise price a future contract thus making buying in unprofitable? Will the new supplier raise price a future contract thus making buying in unprofitable?

35. Deletion of an unprofitable product

36. Deletion of the unprofitable profit In this case we have a multi-product firm In this case we have a multi-product firm Each product is a profit centre Each product is a profit centre For each product attributable costs are allocated For each product attributable costs are allocated Overhead costs are apportioned in some way Overhead costs are apportioned in some way As a result one product appears to be unprofitable and is clearly a candidate for deletion As a result one product appears to be unprofitable and is clearly a candidate for deletion

37. Example £000 Product A Product B Product C Total Sales 50 50 80 80 90 90 220 220 Variable costs 30 30 35 35 40 40 105 105 Fixed costs 35 35 105 105 Profit (loss) (I5) (I5) 10 10 15 15 I0 I0

38. Delete product A? As its sales revenue does not cover full costs it is loss making and should be dropped As its sales revenue does not cover full costs it 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 be lost if A is dropped 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 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 If A is dropped there is no guarantee than overheads will be reduced by £35,000

39. Re-presenting the figures £000ProductAProductBProductCTotal Sales508090220 Variable costs 303540105 Contribution204550115 Less fixed costs 105 Profit 10 10