Contribution margin of a product is the difference between the selling price and its variable cost. It is obtained by subtracting marginal cost from sales revenue of a given activity. The difference between sales revenue and variable cost is called contribution since it contributes towards fixed expenses and profit of the entire business. It is also known as ‘unit contribution margin’ or ‘marginal contribution per unit’. It is one of the tools and techniques used in Marginal Costing.
In normal circumstances, selling prices contain an element of profit but there may be circumstances, when products may have to be sold at cost or even at loss. Therefore, the character of contributions will have the following composition under different circumstances:
- Selling price containing profit: Contribution = Fixed cost + Profit
- Selling price at Cost: Contribution = Fixed Cost
- Selling price at loss: Contribution = Fixed Cost – Loss
This concept is based on the theory that the profit and fixed expenses of a business is a joint cost which cannot be equitably apportioned to different segments of the business. The concept of break-even analysis emerges out of this theory.
The rationale of contribution lies in the fact that fixed costs are done away with under marginal costing. This concept helps to determine the break-even point, profitability of products, departments, etc., to select product mix for profit maximization, and to fix selling prices under different circumstances such as trade depression, export sales, price discrimination, etc. It is the definite test to ascertain whether a product or process is worthwhile to continue among different products or processes.
Some of the specific advantages are as follows:
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.
From the following information, find out the Contribution:
Fixed cost=Rs. 5,00,000
Variable cost= 10 per unit
Selling price= 15 per unit
Output= 1,50,000 unit
The Calculation is as follows:
Contribution = Sales – Marginal cost
= (1,50,000 × 15) – (1,50,000 × 10)
= 22,50,000 – 15,00,000
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