The concept of Contribution Analysis is crucial to the understanding of Break-even Analysis.
What is Contribution Analysis?
Contribution Analysis can help a business to identify products in its Product Portfolio that are relatively profitable and ones that might need more attention to also become very profitably. Any product that makes a positive contribution will help towards paying Fixed Costs (FC) of the business.
How to conduct Contribution Analysis?
Contribution Per Unit is the difference between a product’s Price and its Average Variable Cost (AVC) of production.
Contribution Per Unit = Price – Average Variable Cost (AVC)
Specifically, Total Contribution is simply Contribution Per Unit multiplied by the Quantity produced and sold:
Total Contribution = Contribution Per Unit x Quantity
Or:
Total Contribution = [Price – Average Variable Cost (AVC)] x Quantity
Example 1: Contribution Analysis for the hamburger restaurant A small hamburger restaurant sells five different types of products: hamburgers, hot dogs, pizzas, sandwiches and juice. It has Fixed Costs (FC) of USD$1,000 per month which goes towards paying rent. The following product data shows how Contribution Analysis might be used in order to make business decisions regarding Product Portfolio management.
| Hamburger | Hot-dog | Pizza | Sandwich | Juice | |
|---|---|---|---|---|---|
| PRICE: | $8 | $7 | $25 | $4 | $2 |
| QUANTITY SOLD: | $200 | $150 | $60 | $80 | $100 |
| SALES REVENUE: | $1,600 | $1,050 | $1,500 | $320 | $200 |
| AVERAGE VARIABLE COST (AVC): | $5 | $5 | $18 | $3.5 | $0.5 |
| CONTRIBUTION PER UNIT: | $3 | $2 | $7 | $0.5 | $1.5 |
| TOTAL CONTRIBUTION: | $600 | $300 | $420 | $40 | $150 |
TOTAL SALES REVENUE = USD$4,670 FIXED COSTS = USD$1,000 All five products have positive Contribution Per Unit. It means that the sale of each product in this hamburger restaurant contributes positively towards paying the firm’s Fixed Costs (FC) of USD$1,000. In general, any product that makes a positive contribution is worth considering as it helps towards the payment of Fixed Costs (FC). When it comes to Contribution Per Unit, the strongest product is the pizza despite its relatively high unit cost of production. It earns the firm USD$7 Contribution Per Unit for each pizza sold. The weakest products are the sandwich which only earns the restaurant USD$0.5 Contribution Per Unit sold, and the juice which only earns the restaurant USD$1.5 Contribution Per Unit sold. Also, twice the number of units of juice needs to be sold in order to earn the same contribution as one unit of hamburger. However, when it comes to Total Contribution, all hamburgers sold contributed the most towards paying the firm’s Fixed Costs (FC), and sandwiches contributed the least. It is important to also know the number of units sold before concluding which product is the most profitable. The most popular product when it comes to units sold was the hamburger as 200 burgers were sold. The least popular product was pizza with only 60 pizzas sold. Now, the Profit can also be calculated by deducting total Fixed Costs (FC) from Total Contribution: Profit = USD$1,510 – USD$1,000 Profit = USD$510 Without knowing how much sales of each product this restaurant made, we would not be able to calculate how much profit each product brings.
Benefits of Contribution Analysis
Contribution Analysis has many uses for a business organization. Let’s take a look at the most important benefits of conducting Contribution Analysis:
- Product Portfolio management. By using Contribution Analysis managers can easily decide which products from the firm’s Product Portfolio should be focused on and given investment priority. 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. 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.
- Break-even Analysis. In Break-even Analysis, a business breaks-even when neither a profit nor a loss is made. This occurs at the level of output where Sales Revenue equals to Total Costs (TC). Breaking-even to survive is an important objective of most new and unestablished firms. So, businesses need to pay very careful attention to two things. First, making sure that the money is coming into the business from various revenue streams. And second, that the money leaving the firm through different types of costs is under control. Selling products which make positive contribution is desirable while selling products which make negative contribution is not desirable for the firm.
- Pricing strategy. Contribution Analysis helps a business organization to set accurate prices for each of its products in the Product Portfolio. This will ensure that each product makes a positive Contribution Per Unit. Therefore, in this way, all of the products are ‘useful’ as they all help the firm to pay its Fixed Costs (FC) that must be paid anyway regardless what products and how many products the business produces and sells.
- Allocation of Indirect Costs (Overheads) to Cost Centers and Profit Centers. The use of Contribution Analysis can ensure that costs are allocated properly into different Cost Centers. By having Cost Centers, it allows a business organization to identify which costs are clearly attributed to the activities of each product, unit, section, department or branch. This will help managers to have better control over costs as they are able to clearly see how each Cost Centers contributes towards the firm’s overall Total Costs (TC). Different Cost Centers will also be held accountable for their individual performance.
- Make-or-buy decisions. Contribution Analysis helps a firm to decide whether it should produce (make) a product, or purchase it (buy) from outside suppliers instead. The manager might make that decision whether to make or buy the product based on Contribution Per Unit. When Contribution Per Unit is higher when making the product rather than buying it, then the business should make the product by itself. When Contribution Per Unit is higher when buying the product rather than making it, then the business should buy the product from other businesses.
- Special order decisions. Some customers place orders at a price that is lower than the normal market price charged by the business. It happens when the customer does not have enough budget, or when a large amount is bought in bulk. So, the question is whether the business should sell the product for lower price from time to time? The answer and the decision will depend on the Total Contribution made from such a deal (Price > Average Variable Cost (AVC)). The business should accept the new order as long as additional contribution can be earned. This is because Direct Costs (Overheads) must be paid anyway. If contracts are accepted using prices below the full unit cost, this can lead to an increase in the total profits of the business.
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.
Remember that the main business objective for for-profit businesses is indeed to increase Total Contribution hence to increase Profit, not to decrease it by lowering product prices.
