Contribution is the difference between sales and variable cost or marginal cost of sales. It may also be defined as the excess of selling price over variable cost per unit. Contribution is also known as Contribution Margin or Gross Margin. Contribution being the excess of sales over variable cost is the amount that is contributed towards fixed expenses and profit.
If the selling price of a product is Rs. 20/- per unit and its variable cost is Rs. 15/- per unit, contribution per unit is Rs. 5/- (i.e. Rs. 20-15). Further, let us say that the fixed expenses are 50,000 and the total number of units sold is 8,000. This means that the total contribution is 8000 × 5 or Rs. 40,000 which is not sufficient even to meet the fixed expenses and the result is a loss of Rs. 10,000 (50,000 – 40,000).
In case, the output is 10,000 units, then total contribution of Rs. 50,000 equals the fixed cost, and no amount is left for profit. The profit can be earned only when the amount of contribution exceeds the fixed costs.
Hence, any output beyond 10,000 units, will give some profit e.g., at a level of output of 15,000 units, the total contribution is 15,000 × 5 = Rs. 75,000 while the fixed costs remain Rs. 50,000, thus making a profit of Rs. 25,000.
Contribution can be represented as:
Contribution = Sales – Variable (Marginal) Cost
or Contribution (per unit) = Selling Price – Variable (or marginal) cost per unit
or Contribution = Fixed Costs + Profit (—Loss)
Advantages of Contribution:
The concept of contribution is a valuable aid to management in making managerial decisions.
A few benefits resulting from the concept of contribution margin are given below:
i. It helps the management in the fixation of selling prices.
ii. It assists in determining the break-even point.
iii. It helps management in the selection of a suitable product mix for profit maximisation.
iv. It helps in choosing from among alternative methods of production; the method which gives highest contribution per limiting factor is adopted.
v. It helps the management in deciding whether to purchase or manufacture a product or a component.
vi. It helps in taking a decision as regards to adding a new product in the market.
Marginal Cost Equation:
For the sake of convenience, a marginal cost equation can be derived as follows:
Sales – Variable cost = Contribution
or, Sales = Variable cost + Contribution
or, Sales = Variable cost + Fixed Cost ± Profit/Loss
or, Sales – Variable cost = Fixed cost ± Profit/Loss
or, S – V = F ± P
where ‘S’ stands for Sales
‘V’ stands for Variable cost
‘F’ stands for fixed cost
‘P’ stands for Profit/Loss
The marginal cost equation is very useful in the sense that if any three factors out of the four are known, the fourth can easily be found out.
Determine the amount of variable cost from the following particulars:
The marginal cost equation is:
Sales – Variable cost = Fixed Cost ± Profit/Loss
or 1,50,000 – V.C.= 30,000 + 40,000
or Variable cost = 1,50,000 – 70,000 = Rs. 80,000.
From the following information find out the amount of profit earned during the year using the marginal costing technique:
S – V = F + P
Sales = rs. 75,000 × 15 = Rs. 11,25,000
Variable Cost = 75,000 × 10 = Rs. 7, 50,000
Fixed Cost = Rs. 2, 50,000
Profit (P) = ?
11,25,000 – 7,50,000 = 2,50,000 + P
3,75,000 = 2,50,000 + P
P = 3,75,000 – 2,50,000
Profit = Rs. 1,25,000