Contribution-Costing Technique, or Marginal Costing, is a method of costing in which only Direct Costs are allocated to products, divisions or departments of the business, not Indirect Costs (Overheads).
Contribution-Costing Technique solves the problem of deciding on the most appropriate way to apportion, or share out, Indirect Costs (Overheads) – it does not apportion them at all.
This method assumes that Indirect Costs (Overheads) must be paid during a particular time period regardless of the level of production for each product. So, each product will contribute towards paying Indirect Costs (Overheads), rather than a specific amount of Indirect Costs (Overheads) will be assign to the particular product as there might be inaccuracies or arbitrary allocations.
Contribution-Costing Technique avoids apportioning Indirect Costs (Overheads) between different products. In other words, all product that the business produces will contribute more or less towards paying Indirect Costs (Overheads).
While Full-Costing Technique is better for single-product firms, Contribution-Costing Technique has an advantage when management plans to make important decisions about products based on costs data. This method specifically helps to take appropriate actions when faced with the option which products to continue producing, which products to scrap altogether, or whether to accept a new contract or not depending how much ‘contribution’ that contract can bring towards paying total Indirect Costs (Overheads).
So, the real question here is, how much each product contributes towards paying Indirect Costs (Overheads).
What is contribution?
Contribution measures how much is being contributed to pay Indirect Costs (Overheads) by the units of a particular product that have been produced and sold.
The contribution of a product equals to Sales Revenue gained from selling the product less its total Direct Costs:
Total Contribution = Sales Revenue – Direct Costs
Contribution is not the same as profit:
Profit = Sales Revenue – [Direct Costs + Indirect Costs (Overheads)]
To reach profit, the firm still needs to pay Indirect Costs (Overheads). Therefore, Indirect Costs (Overheads) cannot be ignored altogether. They are indeed very needed to calculate the final profit or loss of the business:
Profit = Total Contribution – Indirect Costs (Overheads)
When the amount of contribution is higher than Indirect Costs (Overheads), then the profit will be earned. It means that products contribute more than enough to cover all Indirect Costs (Overheads), and all Direct Costs of course.
When the amount of contribution is lower than Indirect Costs (Overheads), the loss will be made. It means that products contribute less than enough to cover all Indirect Costs (Overheads), and all Direct Costs of course.
Example of Contribution-Costing Technique
We know from the previous article about Full-Costing Technique that our fast-food restaurant sells four different products: hamburgers, hot-dogs, pizzas and sandwiches.
Total Sales Revenue in this business equals to USD$20,000. This time, Indirect Costs (Overheads) are not allocated on the basis of the proportion of total labour costs incurred by all four products. Instead, the contribution of each product towards paying Indirect Costs (Overheads) of USD$10,000 is calculated. The contribution-costing statement will look like this:
| Hamburgers | Hot-dogs | Pizzas | Sandwiches | |
|---|---|---|---|---|
SALES REVENUE | $6,000 | $7,000 | $4,000 | $3,000 |
DIRECT COSTS | $1,400 | $700 | $2,800 | $1,100 |
| DIRECT MATERIALS: | $1,000 | $500 | $2,000 | $500 |
| DIRECT LABOR: | $400 | $200 | $800 | $600 |
INDIRECT COSTS (OVERHEADS) = USD$10,000 | ||||
| CONTRIBUTION: | $4,600 46% | $6,300 63% | $1,200 12% | $1,900 19% |
The contribution of hamburgers toward paying Indirect Costs (Overheads) equals to the sales revenue of USD$6,000 minus the Direct Costs of producing those hamburgers which gives USD$4,600. So, hamburgers contribute USD$4,600 towards paying aforementioned total Indirect Costs (Overheads) of USD$10,000 for the whole business. This is not that bad as hamburgers cover 46% of all Indirect Costs (Overheads), almost half of all total Indirect Costs (Overheads). Hot-dogs contribute the most (USD$6,300) towards paying total Indirect Costs (Overheads) and pizzas contribute the least (USD$1,200).
Now, let’s calculate the profit by subtracting total Indirect Costs (Overheads) from total contribution. Total contribution for this restaurant equals to USD$14,000 (USD$4,600+ USD$6,300+ USD$1,200+ USD$1,900). When total Direct Costs equal to USD$6,000, this means that the profit is USD$4,000. So, this restaurant makes the profit of USD$4,000.
This link between contribution to Indirect Costs (Overheads), and then to profit, is a crucial one. We can clearly see the role of contribution costing in pricing decisions.
Why is Contribution-Costing Technique also called Marginal Costing?
Marginal cost is the cost of producing one more unit of output, for example producing one more hamburger. This extra cost is a Direct Cost.
Let’s say that Total Cost (TC) of producing 100 units is USD$400,000, and Total Cost (TC) of producing 101 units is USD$400,050. So, the marginal cost is USD$50.
Then, that 101st unit is sold for USD$70. The unit contribution is found as the difference between the sale price of USD$70 and the marginal cost of USD$50. So, the unit contribution towards paying Indirect Costs (Overheads) is USD$20. This is how we calculate Unit Contribution:
Unit Contribution = Price – Marginal Cost
This is not the same as profit. We know that already that in order to calculate profit, we can do that only after Indirect Costs (Overheads) have also been deducted from contribution.
Evaluation of Contribution-Costing Technique
Contribution-Costing Technique avoids all this mess with the allocations of Indirect Costs (Overheads) into each particular product. All costing and pricing decisions about the product will not be made any longer on potentially inaccurate and arbitrary calculations in Full-Costing Technique, but based on the product’s contribution towards paying Indirect Costs (Overheads).
Contribution-Costing Technique is widely used by companies which face typical production dilemmas:
By accepting a new order even though the contract may not bring the business any profit, it can still contribute towards paying Indirect Costs (Overheads) while effectively using any excess production capacity.
One of the real dangers for Operations managers when using Contribution-Costing Technique is that contribution is confused with profit. Also, Indirect Costs (Overheads) could be overlooked in the process as they are set aside, until the final calculation of the business’s profit or loss is conducted. Therefore, the business manager should wait until the end to make any pricing decisions for the product. Indirect Costs (Overheads) cannot be overlook as they eventually need to be paid.
Contribution-Costing Technique is rather useless for businesses that produce only one product. It is because that one product has to cover all Indirect Costs (Overheads) anyway from its sales revenue, so there is no point in calculating any contribution whatsoever.
Another drawback is that Operations managers will not know which products incur much higher Indirect Costs (Overheads) and which products incur much lower Indirect Costs (Overheads). They may decide to stop producing a product which has low contribution, but also has minimal proportion in total Indirect Costs (Overheads).
When managers make their decisions only considering quantitative factors such as the amount of contribution and profit each product makes, they may accidentally scrap those products that give the firm positive image as being a part of the range of goods or a part of the collection. Then, the whole range will lose the appeal to customers.
Also, some products with low contribution may have very loyal customers, can bring new customers or allow the business to enter into a new market segment. Therefore, qualitative factors should also be considered when using Contribution-Costing Technique.
