<CONTRIBUTION COSTING (HL)>
Vs
COSTING METHODS are just different ways to answer the same question:
"How much of our total costs need to be assigned to the production of one unit of product X?"
Sounds simple, right! When we were tackling costs back in UNIT 3.3 we saw that units of output have clearly identifiable DIRECT COSTS and not so easily identifiable INDIRECT COSTS but the calculation is relatively straightforward as we can add them together and divide by the quantity right! Hmmm that's correct IF YOU ONLY PRODUCE A SINGLE PRODUCT, however WHEN YOU PRODUCE MORE THAN ONE PRODUCT, things get a bit tricky as:
Different products are made in different quantities.
They use different amounts of variable costs (e.g. raw materials...)
They also use fixed resources differently (e.g. factory space...)
So now the question becomes:
"How much of our costs should be assigned to making one unit of Product X, and how much to making one unit of Product Y?"
It’s no longer fair to just divide total costs by the total number of units. Each product uses resources in its own unique way — and costing methods help us figure out how much each product truly costs to make.
'ABSORPTION COSTING'
This costing method is called ABSORPTION COSTING (also called full costing) is focused on answering this question
"What is the 'full cost' of producing one unit of each type of product?"
This 'full cost' means that it will USE ALL VARIABLE AND FIXED COSTS (Both direct and indirect) that are attributed to that product (It "absorbs" a portion of all the costs involved in making it.
In other words it works out the 'FULL COST PER UNIT'
--HOW IT WORKS?--
DIRECT COSTS (Both variable and fixed) are clearly identifiable per unit are assigned as normal. Then both INDIRECT VARIABLE COSTS (such as electricity, machine maintenance...) and INDIRECT FIXED COSTS (like rent, supervisors salaries) are COMBINED as OVERHEADS then ABSORBED into the cost of each unit. But how? By using some form of common base that most fairly reflects how the products use the resources:
--EXAMPLE--
A labour-intensive firm may use 'labour hours' as the base, as such they will work out the proportion of labour hours used per product, say 80% on Product A, and 20% on product B, then work out total overheads, and assign 80% to Product A, then divide this amount by the total output of Product A to get an 'Overhead per unit of Product A' that fairly reflects how much it "used up" the factory’s labor resources.
'CONTRIBUTION COSTING'
This costing method is called CONTRIBUTION COSTING and is focused on answering this question:
"After deducting variable costs, how much does each unit 'contribute' to covering fixed costs and profit?"
Thus contribution costing will ONLY USE VARIABLE COSTS (Both direct and indirect) that are attributed to that product
In other words it works out the 'CONTRIBUTION PER UNIT'
CONTRIBUTION = REVENUE - VARIABLE COSTS
TOTAL CONTRIBUTION = the total contribution of all units sold, therefore...
TOTAL CONTRIBUTION > FIXED COSTS, then the SURPLUS is PROFIT.
TOTAL CONTRIBUTION < FIXED COSTS, then their is A LOSS.
--HOW IT WORKS?--
VARIABLE COSTS (Both direct and indirect), like materials, electricity, labour... are directly traced to each product and deducted, what remains in terms of the difference between the selling price and this cost is termed the 'contribution per unit'.
&
FIXED COSTS (like rent, supervisors salaries) are NOT DIVIDED among products
Ask yourself "If your selling price is below your full cost per unit, yet the contribution per unit is positive should you still sell it?"
At first you may say "No chance!", why sell a product at a price lower than its full cost, surely it's just a waste of money, right?!"
If this is the case then ask yourself this: "Why do half empty hotels and restaurants stay open when they are clearly not covering their full costs?"
Got it yet? Full cost per unit includes a share of fixed costs (like rent, salaries, insurance) which are costs that you have to pay whether or not you sell anything. They're sunk for the period.
So if the selling price is above the variable cost, you're making a positive contribution per unit. That means every unit you sell is at least helping to pay off the fixed costs, it's better to cover some of your fixed costs than none at all. you're just reducing losses just not increasing profit.
See the two examples below, restaurants, hotels, planes etc. that are below capacity often can't cover the full cost, but by staying open they can cover variable costs and make some contribution towards paying the fixed costs that they have to pay regardless.
Contribution @20k units = Revenue@20k units - (TC-TFC @20k units)
Contribution @20k units, $200,000 - ($150,000 - $50,000)
Contribution @20k units = $100,000
⚠️IGNORES FIXED COSTS⚠️
⚠️ 2. Not Suitable for External Reporting
Example:
A publicly listed electronics firm uses contribution costing internally to assess which gadgets generate the most margin. However, when it submits its accounts to auditors, it must use absorption costing, allocating fixed costs across all units, as per financial reporting standards.
This creates a mismatch between internal insights and external obligations.
⚠️ 3. Risk of Misusing for Strategic Decisions
Example:
A clothing company uses contribution costing to assess which product lines to invest in long term. It decides to expand a low-variable-cost T-shirt line based solely on its high contribution margin. But they fail to account for rising fixed costs (e.g. needing more warehouse space and staff), leading to lower-than-expected profits after expansion.
⚠️ 4. Overemphasis on Variable Costs
Example:
A video game company uses contribution costing to analyze profitability. Their games have very low variable costs (downloads cost virtually nothing), but high fixed costs (developers, designers, servers). Contribution costing shows great margins, but doesn’t highlight how many units need to be sold to break even.
Management may overestimate success without realizing the weight of fixed costs.
⚠️ 5. Assumes Linear Cost Behavior
Example:
A school’s cafeteria uses contribution costing to decide meal pricing. It assumes food costs are variable and rent is fixed. But if the school rolls out more hot lunches, it needs to hire an extra chef – a step cost not reflected in the model.
This results in underestimating costs at higher output levels.
⚠️ 6. Can Lead to Misleading Profitability Judgments
Example:
A manufacturer sees that Product X has a high contribution per unit, so they ramp up production. However, when total profits fall, they realize that Product X required extra customer support and after-sales service — hidden fixed costs not considered in the contribution costing.
The product wasn’t truly profitable after all.
"Why would you calculate costs using only variable costs?"
Because averaging out fixed costs isn't always fair and some products that use a lot of them will look less expensive whilst other products that use a lesser amount will look more expensive. Therefore using only variable costs will give the operations manager a better idea of which product has the lower cost per unit and is more profitable.
It's perfect for working out which product is more profitable and whether they shoul dmake more of one and less of another.