The use of contribution analysis cannot be fully understood if the meaning of the term is not first explained. Hence, I would like to start with the definition of contribution analysis, and how it is calculated.
Contribution analysis is defined as: the payment made by individual products towards recovering the fixed cost of a business, this payment quickly become profits once the fixed cost of a business has been fully met.
It is calculated thus: unit selling price of a particular product less variable cost of producing that product.
The concept of contribution analysis is centered on variable costs as they are the relevant costs as far as decision making is concerned. Relevant costs are cost that can be avoided if not for taking up a task or project just like relevant cash flows.
Example of contribution calculation
Cost card $ $ $
Sales price 100
Variable overheads 20
Marginal cost 65
Fixed cost 10
Total absorption cost 75
The above example reveals that producing and selling another unit will allow the company to make a contribution of $35 without incurring additional fixed costs. Contribution analysis is based on marginal cost concept, not the subject of this article.
BENEFITS | USES OF CONTRIBUTION ANALYSIS
Generally, contribution analysis is a powerful decision making and budgeting process tool that management accountant functions and managers use to aid most managerial decision making processes. Below are some specific situations where contribution analysis is handy.
FIXING MINIMUM SELLING PRICE: It is a good idea for companies to target selling prices that will cover both fixed and variable costs, but there are times when factors beyond the control of the business may arise subsequently leading to a situation when stocks are being piled in the warehouse, all of a sudden, a willing buyer approaches the entity with an offer below the fixed selling price of the business. Decision needs to be made as to whether to sell at that only available price or not, this is one of the instances when the right decision will be made using the contribution analysis that we have described above. The extra money earned will be used to reduce the fixed cost of the business.
BREAKEVEN CALCULATION: A business that starts operation today does not make profit if it doesn’t make sales to help write off the initial cost of starting a business. Break-even point is that point where a firm neither makes a profit nor loses.
Referring back to our initial example, each unit of product that is sold brings in $100 with a contribution of $35 to gradually reduce the original lose (I will assume that the company is able to produce and sell 10,000 units of a particular product). This will make our business to incur a fixed cost of $100,000 ($10 X 10,000 units) The contributions act like a ladder with each ring representing the contribution that will ultimately take you to the point you are aiming at getting to (i.e., writing off the fixed cost, seen as lose now and making profit in the long run)
To break-even, you will have to climb
100,000 / 35 = 2,857 rings of the ladder, .i.e. make and sell 2,875 units of the product.
This small example may have revealed to you that the general formula for working out break-even point is:
FIXED COST/CONTRIBUTION PER UNIT, If our fixed cost in the above example were to be $50,000 and our contribution $20, our breakeven point would be:
$50,000/$20 = 2,500 units
CONTRIBUTION ANALYSIS ALLOWS US TO DRAW A PROFIT VOLUME CHART: a profit volume chart is a graphical way of explaining the relationship between volume and profit. The graph is plotted with the contribution figure as a variable and it tells manager in a glance what profit will be at a given level. This is beneficial to those managers that are non technical and afraid of dealing with many figures.
CONTRIBUTION ANALYSIS IS USEFUL IN KNOWING HOW LOW A SALE CAN BE BEFORE A COMPANY STARTS MAKING LOSSES. This is known as margin of safety. Through the calculation of margin of safety, a company will know how to plan ahead and this is made possible by leveraging on the benefits of contribution analysis. Margin of safety is expressed in percentage so as to make it easier for managers to understand. For example, if our break-even unit is 2,500 units, and our budgeted sale is 5,000 units, then our margin of safety would be:
5,000-2,000/5,000 X100 = 50%
Contribution analysis helps managers see the effects of changes in costs and selling prices on the company: variables like; variable cost, selling cost or even fixed cost can change and have effect on our bottom line.
There are other uses and benefits of contribution ratio analysis that accountants and other information processing professionals need to know in order to help them make calculated decision in this challenging business world, but, I will however leave you to digest the ones I have identified in this article. Just before I go, remember that;
One of the importances of accounting is that users of accounting information which includes the mangers would get insight into making investment decisions and appraising investment opportunities. Contribution analysis is indeed a very useful managerial decision making tool. If you have been using it, I encourage you to do so. But care needs to be taken while using it just like variance analysis.
Off I go!