Contribution analysis for multi-product firms
Calculating the profitability of a product relies on the firm being able to establish the costs that it incurs in production. However, firms that manufacture more than one product may do so in shared facilities. For example, a firm may have one factory containing three product lines. For each product, it may be possible to identify exactly the amount of raw materials being used, the cost of the employees working on that line and additional costs such as transport and packaging. These direct costs can be deducted from the revenues that product earns. However, what does the firm then do with the bills for utilities, such as electricity, water and gas? Even more problematic are back-office expenses, such as the salaries of support staff in IT, Marketing or Human Relations departments - how are their salaries allocated?
Contribution analysis works on the principle that any division of these costs is likely to be arbitrary and inaccurate. For example, any employee working in marketing would have to record every minute spent working on the marketing of a particular product so that the correct proportion of his/her salary could be charged to that product. However, how would the charge be made if the employee was working on a promotion for the firm itself, rather than a particular product?
Contribution analysis adopts the principle that only the costs directly attributable to a product will be allocated and deducted from revenue and that the remaining figure is that product's contribution to the unpaid fixed and indirect costs (overheads). To calculate whether a multiproduct firm makes a profit overall, the contributions for every product are totalled and then compared to the unpaid fixed and indirect costs.
The following formula is then used to calculate the firm's profit:
Profit = Total contribution - (Total fixed costs + total indirect costs)
Using this method of unapportioned fixed costs and indirect costs means that a product may be retained as long as it makes a positive contribution.
This method of costing can be used for the following:
- Setting of product priorities - the products with the highest contribution are considered the most viable and given the highest investment/marketing priority. Look again at McDonalds Soups. Soup variety G makes the greatest contribution per unit, so should be supported. However, add quantities and the picture might change.
|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|
The situation appears very different once demand is factored into the analysis. Soup variety F now appears to be the best proposition.
- Product portfolio management - any new product will have to earn more contribution than the one it replaces. However, the contribution used (unit or total) will affect the result as illustrated above.
- Make or buy decisions - these are decisions about whether the firm should produce goods themselves or buy them in.
- Acceptance of special orders - this method helps firms, which do not usually use contribution costing, come to a decision on whether to supply at a price different to the one it normally charges (see next page for further details).