Contribution to fixed costs
To make a profit, the price charged for a product or service must cover both fixed and variable costs. Contribution really is shorthand for the term 'contribution to fixed costs and overheads'. If average variable cost is deducted from the unit price the amount left is a contribution to fixed costs.
Contribution is the difference between price and the direct, or variable costs, of a product or service.
For a multi-product firm, total contribution can be calculated by the formula:
A product is worth making and selling if it makes a contribution to fixed costs. Since fixed costs have been paid already, any contribution is better than nothing. In this form of costing, fixed costs or overheads are treated as a cost centre. This makes them visible rather than hiding them in a notional product cost.
Let's look at Low Fidelity Ltd. It produces DVD players and DVD units for computers. The firm knows the following financial details:
|Fixed costs||$100,000 per week|
|Variable costs||DVD||$50 per unit|
|Computer units||$65 per unit|
|Selling price||DVD||$220 each|
|Computer units||$180 each|
DVD's make a contribution of $170 each and the computer units $115 each. The profits cannot be divided between the products. The total profit made by the firm is known, however, as is the contribution each product line makes.
|Contribution analysis - Student Computers plc - sales Units $'000's|
Any or all of the following will increase profits:
- Increasing sales of products
- Decreasing unit variable costs
- Reducing overheads.
Contribution can also be calculated on a per unit basis and used in the same way, for example:
|Contribution analysis - McDonalds Soups plc|
|Price per unit||10.50||8.75||12.54||22.75||13.45||10.00||26.45|
|VC per unit||5.25||1.36||4.27||11.75||6.75||5.00||12.00|
|Contribution per unit||5.25||7.39||8.27||11.00||6.70||5.00||14.45|
All are worth making since they all have a positive contribution. Soup variety F, however, is the most vulnerable if McDonalds Soups is looking to rationalise its product range.
Overhead costs are thus put under the microscope.