Contribution and Marginal Costing Essay

This is an important business concept and must never be confused with profit. The contribution of a product refers to how much it contributes to the fixed costs and profit of the business once variable costs have been covered. It can be calculated either per unit of output or in terms of total contribution of all units produced. Contribution ignores fixed costs and only considers any surplus left once variable costs have been subtracted from revenue. Hence, contribution is what a product contributes towards the fixed costs of the business and, once these are paid, the profits of the business. Managers need to know, as accurately as possible, the cost of each product or service produced by the firm. One reason for this is the need to make a pricing decision. In fact, buyers of many products will want an estimated price or a quotation before they agree to purchase. Managers may also need to decide whether production should be stopped, stepped up or switched to new methods or new materials. Managers also need to compare actual product costs with original budgets and to compare the current period with past time periods. In calculating the cost of a product, both direct labor and direct materials are often easy to identify and allocate to each product. For instance, the materials used in making product X are allocated directly to the cost of that product. These are not the only costs involved. Overheads, or indirect costs, cannot be allocated directly to each product but must be ‘shared’ between all of the items produced by a business. There is more than one costing method that can be used to apportion these costs and, therefore, there may be more than one answer to the question: ‘How much does a product cost to produce?’ contribution costing method that only allocates direct costs to cost/profit centers not overhead costs. This approach to costing solves the problem of how to apportion or divide overhead costs between products – it does not apportion them at all. Instead, the method concentrates on two very important accounting concepts: †¢Marginal cost is the cost of producing an extra unit. This extra cost will clearly be a variable direct cost. For example, if the total cost of producing 100 units is $400 000 and the total cost of producing 101 units is $400 050, the marginal cost is $50. †¢The contribution to fixed costs and profit. This is the revenue gained from selling a product less its variable direct costs. This is not the same as profit, which can only be calculated after overheads have also been deducted. For example, if that 101st unit with a variable (marginal) cost of $50 is sold for $70, it has made a contribution towards fixed costs of $20. The unit contribution is found as the difference between the sale price ($70) and the extra variable cost ($50), that is $20.