Back to Basics: What is contribution?
The idea of ‘contribution’ is a pivotal one in Business Management, and it actually features in nearly half of the BM modules! Let’s get back to basics with it.
We use the word ‘contribution’ often in everyday life, such as discussing sport; ‘Wales couldn’t have made it to the Euro 2016 Semi-Finals without the contribution of the whole team.’
In Business Management terms, contribution is defined as sales less variable costs. It embraces the management or marginal accounting profit and loss statement which is laid out as:
Contribution can be calculated on a ‘total basis’ or on a ‘per unit basis’. For example:
- If the selling price per unit of Product A is £20, and the variable costs per unit are £10, then the contribution per unit is £20 - £10 = £10.
- This means that for every unit you make and sell of Product A, profit will increase by £10.
When a company makes a range of different products, it’s really important to know which product gives the highest contribution per unit: prioritising the higher contribution products will ultimately result in the business making more profit.
The exception to this is a scarce resource (as discussed in BM Module 14). For example, in a particular month a company doesn’t have enough labour hours to satisfy maximum demand. In that month, the company should prioritise the product with the highest contribution per labour hour if there is no subcontractor available, or the highest saving per hour from making the products in-house if there is a subcontractor available.
Contribution also allows the company to budget and plan much more easily, and BM Module 13 teaches you a range of business measures that are brilliant for planning purposes.
- Break-even point is the number of units you need to sell or the revenue you need to achieve so that you break-even (i.e. you won’t make a loss, or a profit). This is a good target figure for a company, as once they achieve the break-even level they know that every sale they make after this will result in profit. Break-even can be calculated as:
- Break-even units = Fixed costs / contribution per unit
- Break-even revenue = Fixed costs / CS ratio
Sometimes it’s also useful to work out the break-even per labour hour or per kg. This is particularly useful if you think you might need to spend more on labour or material than planned. This allows you to work out how much you can afford to spend on it, while still avoiding a loss.
- Margin of safety is the difference between your current or budgeted position and your break-even point. This can be thought of as a ‘cushion’: bigger margins of safety are better, as it means that if the business is impacted by negative occurrences such as lower sales, then you are still likely to make a profit.
- A business might decide at the start of the period what target profit to aim for. They would need to work backwards from this target profit to determine things like the selling price that will allow them to achieve the target profit.
- The specific impact on revenue of selling more units is determined by the CS Ratio, otherwise known as the contribution / sales ratio. If you have a CS ratio of £0.40 it means that for every extra pound of revenue you achieve, profit will increase by £0.40. Clearly again, just like contribution, a business should strive to have a high CS ratio as this will lead to bigger profit increases for the company.
In summary, contribution is a really great tool for business managers to work with, and a real cornerstone of management accounting.