Contribution and Marginal Costing

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.