Contribution (analysis) (HL only)

Make or buy analysis is a quantitative tool that involves a business choosing between making (manufacturing) a product in-house or to purchase it from an external provider (outsourced supplier). Hence, a make or buy decision is also referred to as an outsourcing decision.

In-house production enables the organization to have closer control over costs and quality. It also allows the business to have better overall management of the production process. However, using third party suppliers (subcontractors) can create flexibility and capacity for the business, such as dealing with unexpected fluctuations in the level of demand. Subcontractors may also be more productive and cost-effective.

For example, the Ford Motor Company (FMC) buys vehicle seats, tyres, windscreen wipers, as well as many other components and individual parts, for its various trucks and automobiles from numerous suppliers and then assembles them at the FMC's factories. With each component, the FMC must decide if it is more cost effective to make that part internally or to buy that component from an outsourced supplier.

Note that outsourcing also applies to the services sector. Outsourcing is the act of using another organization to provide goods or services. For example, many businesses choose to an external supplier for services such as market research activities, accounting services, IT maintenance, security services, catering services, payroll and data processing services, as well as cleaning and maintenance.

To compare the cost to make (CTM) and cost to buy (CTB), a business needs to consider the direct costs to manufacture a product in-house against the quoted price of a supplier or outsourced third party provider. In general, there are two straightforward quantitative techniques that can be used when businesses decide whether to make or buy. These methods are called the “cost to make” and “cost to buy”. In quantitative terms,

• If the CTM > CTB, the firm will use outsourcing or subcontracting

• If the CTB > CTM, the firm will use insourcing (in-house production).

However, other related factors to consider in deciding whether to make or buy include:

• Whether the business has sufficient capacity, including labour resources, to produce the product in-house.

• Similarly, whether the business has sufficient expertise to make the products in-house. If not, the business may have no choice but to outsource the work to a third-party supplier.

• Whether the supplier is reputable / reliable enough to produce the products in sufficient quantities, to the quality standards, and in a timely manner.

• If the business is relatively small, it may lack negotiation / bargaining power as a customer with its suppliers, which may have detrimental impacts on prices and delivery times.

• The degree of control the business needs or wants. If a particular product has a direct impact on the image or perception of the business, it may be more pragmatic for the firm to make the product in-house rather than relying on an outsourced provider to do so. Conversely, if a particular good or service has little or minimal importance, it becomes easier to shift this to an outsourced provider.

Cost to buy (CTB)

The cost to buy (CTB) method calculates the total cost of subcontracting production to a third-party supplier.

For example, some of the world’s largest electronics companies subcontract production to Foxconn in China. Foxconn is the world’s biggest contract electronics manufacturer. The Taiwanese multinational producer makes products for its clients, which include: Apple (iPad and iPhone), Amazon (Kindle), Nintendo (Wii U), Sony (PlayStation) and Microsoft (Xbox One).

As a customer, the cost to buy (CTB) a product from a supplier is calculated as:

Cost to buy (CTB) = Price × Quantity

or

CTB = P × Q

The CTB method allows the business to calculate the total cost of outsourcing production. If the cost to buy is less than the cost to make, then it makes financial sense for the firm to purchase the product from a third party provider, rather than making it in-house.

Cost to make (CTM)

In a make or buy decision, managers calculate the costs of producing a product compared to the overall cost of buying the product from a supplier instead. The cost to make (CTM) refers to the total costs of producing a good or service in-house, rather than using a third-party supplier. The CTM a good or service in-house is calculated by using the formula:

Cost to make = Total costs of production = Total fixed costs + Total variable costs

or

CTM = TFC + TVC

Fixed costs and variable costs are covered in Unit 3.2 costs and revenues.

In reality, managers consider both qualitative and quantitative factors before making a final decision to make or buy. Examples of qualitative factors include consideration of the reputation of the third-party provider, lead times for deliveries, and the capacity of employees if in-house production is preferred.

Contribution refers to the difference between a firm's sales revenue of a product it sells and the variable costs of production. The surplus is used to "contribute" to the payment of the firm's fixed costs. Any contribution over and above total costs of production is declared as profit for the firm.

There are two ways to express contribution:

• Unit contribution represents the amount of money earned from each unit of the product sold to customers. It is the difference between a firm’s selling price (P) for a product and the average variable cost (AVC) of that product. It represents the amount of money earned from each unit of the product sold to customers.

• Total contribution is the unit contribution (P – AVC) multiplied by the quantity sold (Q), i.e., (P – AVC) × Q. This is the amount used to pay fixed costs; any financial surplus that remains becomes profit for the firm.

For example, suppose a hot dog stall vendor has total fixed costs per month of $3,000. It sells hot dogs for $7 for which the cost of sales are $4.

• In the above example, for each hot dog sold, the vendor earns $7 – $4 = $3 per unit

• So, for each hot dog sold, the vendor earns $3 towards paying its total fixed costs.

• The hot dog stall vendor will need to sell 1,000 hot dogs per month in order to pay for the monthly fixed costs, i.e. $3 × 1,000 hot dogs = $3,000 OR $3,000 / $3 = 1,000 hot dogs.

Formulae

• Total contribution is simply the unit contribution (P – AVC) multiplied by the quantity sold (Q), i.e. Total contribution = (P – AVC) × Q.

• Total contribution can be used to calculate profit or loss by taking away fixed costs from total contribution, i.e. Profit = [(P – AVC) × Q] – TFC.

In general, a product is worth producing and selling if it earns a positive contribution to fixed costs. Since fixed costs have been paid regardless of the level of output, any positive contribution helps to pay off the firm's overheads. With contribution costing, fixed costs (or overheads) are treated as a cost centre. A cost centre is a division of a business that has responsibility for its own operational costs. The cost centre is held accountable for its departmental expenditure. They can help managers to collect and use cost data effectively, thereby having better budgetary control.

Examples of cost centres in the corporate world include:

• Administration

• Customer service

• Finance and accounts

• Human resources

• Legal

• Marketing

• Production

• Purchasing

• Research and development (R&D)

• Technical support

A profit centre is a section or division of a business organization that has both costs and revenues clearly identified and attributed to its operations, which are recorded for budgetary purposes.

Common mistake

Contribution is not the same as value added, although the two terms are often confused by students:

• Unit contribution = Price minus Average variable cost, i.e. P – AVC

• Value added per unit = Price minus Average total costs, i.e. P – ATC

This means that value added considers both variable and fixed costs of production, whereas unit contribution only considers the cost of sales (COS) or the unit variable costs.

Contribution costing is a quantitative technique used to calculate how many items need to be sold to cover all the firm’s costs (both variable and fixed costs). It enables managers to see the financial surplus (contribution) that a firm earns from each unit of product sold and whether that return is sufficient to allow it to earn profit overall, after deducting its fixed costs.

As an example, suppose a single-product business has the following cost and revenue data:

• Selling price per unit = $30

• Variable cost per unit = $18

• Contribution per unit = $30 – $18 = $12

• Units sold = 15,000

Given the contribution per unit is $12, it is possible for the business to increase this by one of two ways:

• Raising the selling price above $30

• Reducing the average variable cost to below $18

Hence, contribution costing enables the business to determine the price it can or should charge for the product.

Using the contribution formulae above, we can determine total contribution for the firm:

Total contribution = $12 × 15,000 units = $180,000

However, note that the total contribution figure is not the same as the overall profit earned by the business, as fixed costs have yet to be accounted for.

Suppose the business in question has overhead (fixed) costs that total $120,000.

The firm’s profit is calculated by the difference between its total contribution and its total fixed costs.

Total profit = Total contribution – Total fixed costs

Therefore, the firm’s total profit = $180,000 – $120,000 = $60,000.

For a multi-product firm, it is possible to calculate the contribution for each product, but not the profit for each product. This is because overhead costs are not directly related to the output of a particular product.

In the example below, the business sells two different products. Suppose the firm has total fixed costs of $25,000 per month.

• Contribution costing is based on the principle that a cost (such as staff wages or raw material costs) is directly attributable to a product. However, the technique does not apportion fixed costs (overheads), which must be accounted for before declaring a profit or loss. Nevertheless, in reality fixed costs and overheads (such as insurance, lighting, depreciation, and rent) are not easily or objectively apportioned to any specific cost centre or profit centre. Absorption costing seeks to apportion these fixed costs between a firm's cost or profit centres.

• Absorption costing is a quantitative method of calculating the cost of a product by taking into account both indirect expenses (overhead costs) as well as direct costs (cost of sales), i.e., it calculates the total cost of producing a product. The criteria use to apportion overheads for each cost or profit centre commonly includes floor space, sales revenue, or the number of staff in each division (to allocate rental costs). Another example is to use the value of machinery to allocate depreciation costs.

Suppose a business operates three separate divisions (or departments) as profit centres, with the following cost and revenue information: