Contribution Analysis is based on Contribution-Costing Technique which is a method of allocating only Direct Costs to products, divisions or departments of the business, not Indirect Costs (Overheads).
How does Contribution-Costing Technique work?
Contribution-Costing Technique 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) proportionally, rather than a specific amount of Indirect Costs (Overheads) will be assign to the particular product. It avoids apportioning Indirect Costs (Overheads) between different products as all products that the business produces will contribute more or less towards paying Indirect Costs (Overheads).
Contribution-Costing Technique is better for companies with multiple products in their Product Portfolios. This method specifically helps to take appropriate actions when faced with the option which products to continue selling and which products to scrap altogether depending on how much ‘contribution’.
The real question here is how much each product contributes towards paying Indirect Costs (Overheads).
Calculations in Contribution Analysis
Contribution Analysis can help a business to identify both profitable products and those with low profitability that might need more development. In general, any product that makes a positive contribution towards paying the firm’s Fixed Costs (FC) is worth considering having in the Product Portfolio.
It is quick to use the formula for total contribution. The total contribution of a product equals to Sales Revenue gained from selling the product less its total Direct Costs:
Total Contribution = Sales Revenue – Direct Costs
Or:
Unit Contribution = Average Unit Price – Average Direct Cost
When a product has positive unit contribution, it contributes towards paying Fixed Costs (FC). And, when a product has negative unit contribution, it does not contribute towards paying Fixed Costs (FC).
So, now the question is whether to stop or not to stop making a product?
How to use Contribution Analysis to manage Product Portfolio?
Contribution-Costing Technique is widely used by companies which face a typical Product Portfolio dilemma – To stop or not to stop making a product?. Let’s take a look at the business selling the following products to shows how Contribution Analysis might be used.
| Hamburger | Hot-dog | Pizza | Sandwich | Coffee | Tea | |
|---|---|---|---|---|---|---|
| Average Unit Price: | $3.50 | $4.75 | $7.55 | $3.20 | $1.55 | $1.80 |
| Average Direct Cost: | $2.25 | $2.55 | $3.15 | $0.95 | $1.05 | $1.00 |
| CONTRIBUTION PER UNIT: | $1.25 | $2.20 | $4.40 | $2.25 | $0.50 | $0.80 |
All products in this restaurant have positive unit contribution. Therefore, the sale of each product positively contributes towards paying the Fixed Costs (FC) of the business.
The strongest product is the Pizza. Despite its relatively high unit cost of production of USD$3.15, it earns the firm USD$4.40 contribution per each unit sold. The most vulnerable product is the Coffee which only earns the firm USD$0.5 contribution per each unit sold.
Almost nine coffees need to be sold in order to earn the same contribution as one unit of Pizza.
Benefits of using Contribution Analysis to manage Product Portfolio
The three benefits of using Contribution Analysis to manage the Product Portfolio include:
- Most important products. In general, the products with the highest Total Contribution are given precedence because thanks to them, the business can pay Fixed Costs (FC) the fastest.
- Products that require investment. By using Contribution Analysis managers can easily decide which products from the firm’s Product Portfolio should be focused on and given investment priority. Added Value should be added to boost the price of those products that earn the lowest Total Contribution to avoid being withdrawn or replaced by other products as those products may have loyal customers nevertheless.
- Products to discontinue. A product should not be discontinued (withdrawn from the market), or reduced in price, because it has the smallest amount of contribution in a firm’s Product Portfolio. It is because even the tiniest of contribution can be used to pay a firm’s Fixed Costs (FC). Discontinuing the product would mean less Total Contribution and hence, less profit in the end. Profit equals to Total Contribution minus Fixed Costs (FC). Instead, the business manager should find a way to add value in order to sell more of those products with low Contribution Per Unit for higher price.
It is important to also know the number of units sold before concluding which product is the most best in the Product Portfolio.
To reach profit, the firm still needs to pay Indirect Costs (Overheads). Therefore, Indirect Costs (Overheads) cannot be ignored altogether as these costs are required to calculate the final profit or loss of the business:
Profit = Total Contribution – Indirect Costs (Overheads)
Products with a higher total contribution tend to be given precedence. Products that earn a low unit contribution rely on high sales volumes to avoid being withdrawn or replaced by other products. Remember that the main business objective for for-profit businesses is indeed to increase Total Contribution hence to increase Profit.
