Contribution (DP IB Business Management)
Revision Note
Written by: Lisa Eades
Reviewed by: Steve Vorster
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
Total contribution is calculated using the formula
Key uses of Contribution Analysis
Make or Buy Analysis | Contribution Costing | Absorption Costing |
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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 = $4.30
Step 2 - Identify the quantity needed to be sold to cover fixed costs
[2]
Step 3 - Identify whether Renflux should make or buy
Fixed costs would only be fully covered if Renflux were to sell 10,000 units
In this case it expects to sell only 6,000 units
Renflux should therefore make the processors in-house [2]
Make or buy analysis is a quantitative decision-making method
However, qualitative factors should also be considered before the decision is made
Qualitative Factors that can Affect Make or Buy Decisions
Qualitative Factor | Explanation |
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1. Available capacity |
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2. Timeframe |
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3. Expertise |
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4. Reputation of suppliers |
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5. External influences |
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Contribution Costing
Contribution costing is a method of costing where direct costs are allocated to products or departments of a business
It assumes that indirect costs must be paid during a particular time period regardless of the level of production for each product
Each profitable product contributes towards paying these overheads
Example: Lickety split desserts
Lickety Split is a seaside ice cream café
It sells a range of ice cream and sorbet-based desserts
The table below shows a contribution analysis for its top-selling products
Contribution Analysis for Lickety Split's Top-Selling Desserts
Product | Average unit price ($) | Average variable cost ($) | Unit contribution ($) |
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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) |
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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
As long as each product achieves its break even point Lickety Split's indirect costs will be covered
Examiner Tips and Tricks
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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