IBBusiness ManagementHLRevision Notes6. The Business Management Toolkit6.1 The Business Management ToolkitContribution

Contribution (HL IB Business Management)

Revision Note

Lisa Eades

An Introduction to Contribution

  • Contribution is generated where the production process adds value
  • This added value contributes to paying a businesses indirect costs (fixed costs)
  • Contribution is the difference between sales revenue and variable costs
    • The amount left over contributes towards paying the fixed costs

  • Contribution per unit is calculated using the formula

   Selling space price space minus space Variable space cost space per space unit

  • Total contribution is calculated using the formula

Contribution space per space unit space cross times space Quantity space of space output

  

Key uses of Contribution Analysis

Make or Buy Analysis Contribution Costing Absorption Costing

Determining whether to manufacture in-house or purchase from a third-party
 
A method of costing where only direct costs are allocated to products
 
A method of costing that allocates both direct and indirect costs to products
 

Make or Buy Analysis

  • This process helps to decide if a business product should be manufactured in-house or outsourced to a supplier
    • If the cost to manufacture (CTM) is lower than the cost to buy (CTB) a business should manufacture the product in-house
    • If the CTB is lower than the CTM a business should outsource production to a third-party supplier

Worked example

Renflux can manufacture processors for $3.50 per unit. It can buy the same product from suppliers for $4.30 per unit. It expects to sell 6,000 processors per month. Renflux has fixed costs of $8,000 per month. [4 marks]

Step 1 - Identify the cost to make (CTM) and cost to buy (CTB)

CTM = $3.50

CTB = $4.30

 

Step 2 - Identify the quantity needed to be sold to cover fixed costs

fraction numerator Fixed space costs over denominator CTB space minus space CTM end fraction equals space fraction numerator $ 8 comma 000 over denominator $ 4.30 space minus space $ 3.50 end fraction equals space 10 comma 000 space units       [2]

 

Step 3 - Identify whether Renflux should make or buy

Fixed costs would only be fully covered if Renflux were to sell 10,000 units

In this case it expects to sell only 6,000 units

Renflux should therefore make the processors in-house  [2]

  • Make or buy analysis is a quantitative decision-making method
  • However, qualitative factors should also be considered before the decision is made
     

Qualitative Factors that can Affect Make or Buy Decisions


Qualitative Factor
Explanation


1. Available capacity
  • Whether the business has sufficient staffing, production facilities and storage to manufacture in-house

2. Timeframe
  • Whether the need for the product is urgent
  • Whether production timescales may be affected if products are not available

3. Expertise
  • Whether the business has the skills and know-how to manufacture the product
  • Whether the supplier has particular capabilities in manufacturing the product

4. Reputation of suppliers
  • Whether the supplier delivers on-time and within budget
  • Whether specifications and desired quantities can be met

5. External influences
  • Whether exchange rates or protectionist barriers affect price or delivery of products from suppliers

Contribution Costing

  • Contribution costing is a method of costing where direct costs are allocated to products or departments of a business

    • It assumes that indirect costs must be paid during a particular time period regardless of the level of production for each product

    • Each profitable product contributes towards paying these overheads

Example: Lickety Split Desserts

  • Lickety Split is a seaside ice cream café
  • It sells a range of ice cream and sorbet-based desserts
  • The table below shows a contribution analysis for its top-selling products
     

Contribution Analysis for Lickety Split's Top-Selling Desserts

Product Average unit price ($) Average variable cost ($) Unit contribution ($)


Super Sundae


8.95


3.45


5.50

Nutty Surprise
9.95
4.25
5.70

Fruit Supreme
8.95
4.30
4.65

Ice Magic
8.95
2.25
6.70

ChocoLick
9.95
6.60
3.35

Data Analysis

  • Ice Magic is the strongest product
    • It earns the highest contribution ($6.70) per product sold

  • ChocoLick is the weakest product
    • It earns the lowest contribution ($3.35) per product sold
    • Twice as many ChocoLick as Ice Magic desserts would need to be sold to generate the same level of contribution

  • All of Lickety Split's products are profitable because the unit contribution is positive in each case
  • This positive contribution can go towards paying Lickety Split's indirect costs of operating the café

Absorption Costing

  • This method determines the most appropriate way to apportion indirect costs to products or departments of a business
    • Indirect costs need to be apportioned so that all costs of production are fully covered
    • Selling prices are then set accordingly
    • This ensures that the business is able, at the very least, to break even

  • A simple way to apportion indirect costs is to split them equally across products or departments

Example: Lickety Split Desserts

  • Lickety Split is a seaside ice cream café
  • It sells a range of ice cream and sorbet-based desserts
  • The business has monthly indirect costs of $7,500
    • Indirect costs are split equally across the five top-selling desserts
  • The table below shows an absorption costing analysis for its top-selling products
     

Absorption Costing Analysis for Lickety Split's Top-Selling Desserts

Product Average unit price ($) Average variable cost ($) Unit contribution ($) Indirect Cost Allocation ($) Break Even Point (desserts)


Super Sundae


8.95


3.45


5.50
1,500
273

Nutty Surprise
9.95
4.25
5.70
1,500
263

Fruit Supreme
8.95
4.30
4.65
1,500
323

Ice Magic
8.95
2.25
6.70
1,500
224

ChocoLick
9.95
6.60
3.35
1,500
448

Data Analysis

  • Indirect costs of $1,500 are allocated to each product equally
  • The break even point for each product can be calculated using the formula

Break space Even space Point space equals space fraction numerator Indirect space Costs over denominator Unit space Contribution end fraction
 

  • As long as each product achieves its break even point Lickety Split's indirect costs will be covered
     

Exam Tip

Other criteria that may be used to allocate indirect costs including

    • Floor area occupied by a product or department
    • Sales volume or value
    • Number of employees
    • Output levels

Use the data provided to accurately allocate the indirect costs to the relevant product - and in the correct proportions

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    Lisa Eades

    Author: Lisa Eades

    Lisa has taught A Level, GCSE, BTEC and IBDP Business for over 20 years and is a senior Examiner for Edexcel. Lisa has been a successful Head of Department in Kent and has offered private Business tuition to students across the UK. Lisa loves to create imaginative and accessible resources which engage learners and build their passion for the subject.