Contribution Costing: A Tool for Profitability Analysis
- Consider you're running a bakery.
- You need to decide whether to make your own pastries or buy them from a supplier.
- How do you determine which option is more profitable?
This is where contribution costing comes in.
Contribution costing
Contribution costing is a financial analysis tool that helps businesses determine the profitability of individual products or activities by focusing on the contribution each makes to covering fixed costs and generating profit.
HL students: Recall how this relates to Cost-to-Make and Cost-to-Buy in topic 5.6.
Key Concepts in Contribution Costing
1. Contribution Margin
- The contribution margin is the difference between sales revenue and variable costs.
- It represents the amount available to cover fixed costs and generate profit.
$$\text{Contribution Margin} = \text{Sales Revenue} - \text{Variable Costs}$$
ExampleA bakery sells a pastry for USD 5, and the variable cost (ingredients, packaging) is USD 2. The contribution margin is USD 3 (USD 5 - USD 2).
2. Total Contribution
- Total contribution is the sum of the contribution margins from all units sold.
- It helps determine how much of the fixed costs are covered.
$$\text{Total Contribution} = \text{Contribution Margin per Unit} \times \text{Number of Units Sold}$$
ExampleIf the bakery sells 100 pastries, the total contribution is \$300 (\$3 × 100).
3. Break-Even Analysis
- Contribution costing is essential for break-even analysis, which identifies the point at which total revenue equals total costs.
$$\text{Break-Even Point (Units)} = \frac{\text{Fixed Costs}}{\text{Contribution Margin per Unit}}$$
ExampleIf the bakery's fixed costs are USD 600, the break-even point is 200 pastries (USD 600 ÷ USD 3).
