IB Docs (2) Team
BMT 14 - Contribution (HL only)
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This section of the Business Management Toolkit covers three aspects of contribution:
(i) Make or buy analysis
(ii) Contribution costing, and
(iii) Absorption costing.
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).
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China has provided many opportunities to use sub-contractors
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)
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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.
Worked example
Consider the worked example below:
A hotel is considering whether to make or buy 3,000 luxury cupcakes for a special function. It can make these for a variable cost per unit of $4.50 per cupcake, and would allocate $4,500 in fixed costs to this order. Alternatively, the hotel can buy the cupcakes from a reputable supplier at a price of $7.0 per cupcake, less 10% discount for the bulk order. In this particular example:
The hotel’s CTM = $4,500 + ($4.50 × 3,000) = $18,000
The hotel’s CTB = ($7.0 × 0.9) × 3,000 = $18,900
Hence, it is cheaper for the hotel to make the cupcakes rather than using the specialist supplier (unless it can offer a discounted price of less than $6.0).
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.
Watch this ABC News coverage titled “Foxconn: an exclusive inside look”, which looks at the conditions that Chinese workers put up with in China, and the implications for companies such as Apple and Disney. Do multinational companies, like Apple, have the moral obligation to tackle the problems highlighted in the video?
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.
Unit variable cost | Product Alpha | $50 |
Product Beta | $70 | |
Selling price | Product Alpha | $220 |
Product Beta | $180 |
Recall that the unit contribution for a product is the difference between the selling price and the average variable cost. As can be seen below, the unit contribution of Product Alpha is $170 whereas it is lower for Product Beta at $110 each.
Product | Price | Unit variable cost | Unit contribution |
Alpha | $220 | $50 | $170 |
Beta | $180 | $70 | $110 |
As mentioned, it is not possible to determine the profits for each product, as fixed costs cannot be directly linked to any of the two different products. The total profit can be calculated as is the total contribution from each product can be determined.
So, if during the month the firm sells 100 units of Product Alpha and 150 units of Product Beta, the following can be calculated:
Total contribution for Product Alpha = $170 × 100 = $17,000
Total contribution for Product Beta = $110 × 150 = $16,500
Total contribution for the firm = $17,000 + $16,500 = $33,500
Profit for the multi-product firm = $33,500 – $25,000 = $8,500
Hence, contribution analysis can help a business to determine which products or aspects of its operations are most profitable and which are not (and therefore in need to corrective measures).
Worked example
Suppose a toy manufacturer makes four toys that it sells to retailers. The producer has fixed costs of $15,000 per month. The sales and cost details are shown below (figures in $ per month).
| Toy | A | B | C | D | Total |
Sales revenue | 20,000 | 30,000 | 18,000 | 22,000 | |
Total variable costs | 15,000 | 20,000 | 12,000 | 10,000 | |
Contribution |
To work out the profit or loss for the toy manufacturer, it is necessary to calculate the contribution for each product and then the total contribution for the producer. From this, the fixed costs ($15,000) are deducted to calculate the profit or loss. Click on the icon to check the missing figures.
| Toy | A | B | C | D | Total |
Sales revenue | 20,000 | 30,000 | 18,000 | 22,000 | |
Total variable costs | 15,000 | 20,000 | 12,000 | 10,000 | |
Total contribution |
Therefore, the firm's overall profit is determined by the following calculation (click on the icon logo below).
Total contribution = $90,000 minus $57,000 = $33,000
Fixed costs = $15,000
Total profit = $33,000 minus $15,000 = $18,000
Essentially, contribution costing plays an important role in pricing decisions. At the very least, it enables managers to know the minimum price that must be charged in order for the product to earn any positive contribution. This is particularly important for cost-plus pricing or mark-up pricing (see Unit 4.5).
Using the example from contribution pricing above, managers can choose to appropriation (attribute or split) the fixed costs equally between the four products. This means $3,750 of the total fixed costs is absorbed by each product (i.e., $15,000 / 4 = $3,750). The gives the following results, with all figures in $'000.
Product A | Product B | Product C | Product D | Total | |
Sales revenue | 15 | 50 | 25 | 40 | 130 |
Variable costs | 10 | 25 | 15 | 30 | 80 |
Overheads | 3.75 | 3.75 | 3.75 | 3.75 | 15 |
Contribution per product | 1.25 | 21.25 | 6.25 | 6.25 | 35 |
Notice how the contribution per product is now lower, as each profit centre must absorb some of the overhead costs of the business, as shown below (all figures in $'000).
Contribution per product | 5 | 25 | 10 | 10 | 50 |
Contribution per product | 1.25 | 21.25 | 6.25 | 6.25 | 35 |
Top tip!
Based on our distinction between "price" (what the customer pays) and "cost" (what the business pays), make sure you do not confuse contribution pricing and contribution costing as they are different. Contribution pricing is part of Unit 4.5 as a pricing method, whereas contribution costing is part of the BMT and used as a method to allocate a firm's indirect costs.
Essentially, contribution costing is a business management tool that can be useful for decision-making (such as setting annual budgets between different functional areas of a business) whereas contribution pricing is a strategy that the business can use (such as specific pricing methods).
Whilst there is some overlap between these two terms, if you are able to distinguish between 'cost' and 'price', the distinction should be more clear.
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:
| Profit centres | Department A | Department B | Department C |
| Sales revenue | 300,000 | 250,000 | 200,000 |
| Direct costs | 165,000 | 125,000 | 120,000 |
Using contribution analysis, we can determine the total contribution for each profit centre:
| Profit centres | Department A | Department B | Department C | Total |
| Sales revenue | 300,000 | 250,000 | 200,000 | 750,000 |
| Direct costs | 165,000 | 125,000 | 120,000 | 410,000 |
| Contribution | 135,000 | 125,000 | 80,000 | 340,000 |
Now, suppose the firm's overheads comprise of $200,000 for rent and $100,000 for administrative costs. The firm's total fixed costs are therefore $300,000. Contribution analysis shows that the total profit is therefore $340,000 – ($200,000 + 100,000) = $40,000.
However, absorption costing would enable managers to have better insight into how each department or division of the business is affected by overhead costs. Additional data for the aforementioned firm are shown below.
| Measure | Department A | Department B | Department C | Total |
| Floor space (sq metres) | 50 | 80 | 70 | 200 |
| Employees (number of) | 40 | 35 | 25 | 100 |
With this additional information, the overhead costs (rent and administrative costs) can be allocated based on the proportion of the costs attributed by each department.
| Rental costs | Department A | Department B | Department C | Total |
| Floor space (sq metres) | 50 | 80 | 70 | 200 |
| Floor space (% of total) | 25% | 40% | 35% | 100% |
| Allocation of rent* | 50,000 | 80,000 | 70,000 | 200,000 |
* The allocation of rent is determined by multiplying the overhead charges ($200,000) by the percentage that each department accounts for. For, for example, Department A accounts for 25% of the total floor space (50 sq m2 as a percentage of 200 sq m2). Hence 25% of the rental costs are absorbed by Department A, i.e. $200,000 × 0.25 = $50,000.
We can also allocate the administrative charges in the same way, based on the number of employees in each department. In theory, larger departments (as measured by the number of employees) contribute towards a larger proportion of the administrative costs of a business.
| Administrative costs | Department A | Department B | Department C | Total |
| Employees (number of) | 40 | 35 | 25 | 100 |
| Employees (% of total) | 40% | 35% | 25% | 100% |
| Allocation of administrative costs* | $40,000 | $35,000 | $25,000 | $100,000 |
* In the case of Department B, with 35 employees out of the total workforce of 100 people, the department is allocated or absorbs 35% of the total administrative costs. Hence, it is allocated $100,000 × 0.35 = $35,000.
The final stage in absorption costing is to enter the figures for allocated overhead costs to each department:
| Profit centres | Department A | Department B | Department C | Total |
| Sales revenue | 300,000 | 250,000 | 200,000 | 750,000 |
| Direct costs | 165,000 | 125,000 | 120,000 | 410,000 |
| Contribution | 135,000 | 125,000 | 80,000 | 340,000 |
| Allocation of rent | 50,000 | 80,000 | 70,000 | 200,000 |
| Allocation of admin costs | 40,000 | 35,000 | 25,000 | 100,000 |
| Profit per department^ | 45,000 | 10,000 | -15,000 | 40,000 |
^ The profit or loss earned from each department is calculated by the formula: Contribution minus Overheads. So, for example, in the case of Department C, the loss is determined as $80,000 – ($70,000 + $25,000) = -$15,000. This means that despite the department earning a positive contribution of $80,000 the department actually makes a loss after rent and administrative charges are accounted for.
From the above analysis and example, it can be seen that Department A is the most profitable division for the business, whereas there may be some financial concerns revealed for Department C.
Although absorption costing is more complex and time consuming than using contribution costing, it is more representative of the situation in reality as fixed costs still need to be accounted for in order to declare a profit or loss. As such, the cost per unit of output is likely to be more accurate if managers use absorption costing. This is particularly important is the firm choosing a cost-plus (mark-up) pricing policy.
However, note that the criteria used to allocate or apportion overhead costs is still arbitrary and subjective to some extent so can lead to some discrepancies and inaccuracies in the results.
To test your understanding of this business management tool (Contribution), have a go at the following multiple choice questions. To support your revision, a brief explanation is provided for the answer.
What is the main purpose of a make or buy analysis?
As the name suggests, a make or buy analysis enables a firm to see whether it should make a product in-house or purchase it from an external provider.
What are two quantitative techniques used to decide whether to make or buy?
The cost to make (CTB) and cost to buy (CTB) enable a firm to determine whether to make a product (if the CTM < CTB) or to buy it from another provider (if the CTB < CTM).
What is the purpose of a business considering a cost to buy (CTB) decision?
A cost to buy (CTB) decision involves the business working out the total cost of using a third-party producer of a good or provider of a particular service.
What are the correct combination of factors that businesses need to consider when making a "make or buy" decision?
When deciding whether to have in-house production or to outsource this, a business needs to consider whether it has capacity to expand and the necessary expertise to do so.
What is the primary benefit of making a product in-house?
Choosing to have in-house production enables the business to have improved control of the production process, whereas the control is diluted if outsourcing or subcontracting are used.
What is an example of a service that a large IB World School in unlikely outsource?
Teaching is (should be) delivered in-house, rather than outsourced (except in exceptional circumstances). It is important that appropriately qualified and experienced teachers delivery the IB curriculum in IB World Schools.
How are the cost to make (CTM) and cost to buy (CTB) methods used to decide whether to make or buy?
If the CTM > CTB, this means it is relatively cheaper to make (in-house provision) than to buy (from an outsourced provider).
What is the formula for calculating unit contribution?
Unit contribution if the difference between the selling price (P) and the average variable cost (AVC) of making or providing that product.
What is the disadvantage of outsourcing a product to a third-party supplier?
Outsourcing production of a product to a third-party supplier means some loss of control of the production process, especially if it lacks negotiation power asa customer.
What is the formula used to calculate the cost to buy (CTB) a product from a supplier?
The cost to buy (CTB) is the total costs of buying a product from a supplier. This does not typically incur any fixed costs.
What is the formula used to calculate the cost to make (CTM) a product in-house?
The cost of make (CTB) a product in-house will include all direct costs associated with the output of the product, i.e., fixed and variable costs that are allocated to the production.
What is the formula for unit contribution?
What is the formula for total contribution? A. B. D.
What is unit contribution?
What is a cost centre?
What is a profit centre?
What is the difference between a cost centre and a profit centre?
When is a product worth producing and selling?
What is the purpose of contribution costing?
What is the purpose of contribution costing?
What is the difference between contribution costing and absorption costing?
What is the main difference between contribution costing and absorption costing?
What kind of information can be obtained from contribution analysis?
What is the purpose of absorption costing?
What is the criteria used to apportion overheads for each cost or profit centre?
What is the purpose of contribution costing?
What is not possible to determine using contribution costing?
What kind of information can be obtained from absorption costing?
What is the purpose of absorption costing?
What is the definition of absorption costing?
What is the cost to buy (CTB) method? A. B. C. D.
What is make or buy analysis?
What is make or buy analysis?
What is a cost centre?
What is a profit centre?
(a) | Describe the meaning of a make or buy decision. | [2 marks] | ||||||||||||||||||||||||
(b) | Distinguish between total contribution and unit contribution. | [4 marks] | ||||||||||||||||||||||||
(c) | Complete the table below to determine the contribution per product and the overall profit for the business if it uses contribution costing. All figures in the table are in $'000. The firm's total fixed costs are $30,000. |
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Teacher only boxAnswers
(a) Describe the meaning of a make or buy decision. [2 marks]
A make or buy decision is a BMT that compares the financial costs and benefits of producing a particular good or service in-house (internally) with the costs and benefits of hiring (paying for) an outsourced supplier to provide the product in question.
Award [1 mark] for a limited response that shows some understanding of the demands of the question.
Award [2 marks] for a definition that shows good understanding, similar to the example above.
(b) Distinguish between total contribution and unit contribution. [4 marks]
Total contribution refers to the difference between a firm's total sales revenue (TR) and its total variable costs (TVC), i.e., TR – TVC. The numerical difference is then used to pay the firm’s total fixed costs (TFC).
By contrast, unit contribution is the difference between the price (P) of a product and its average variable cost (AVC), i.e., P – AVC. The difference represents the profit margin or markup per each unit sold.
Award [1 - 2 marks] for an answer that shows some understanding of the demands of the question. The distinction between the two terms is not made clear.
Award [3 - 4 marks] for an answer that shows good understanding of the demands of the question. The distinction between the two terms is explicit and made clear. There is effective use of appropriate terminology throughout the answer.
(c) Complete the table below to determine the contribution per product and the overall profit for the business if it uses contribution costing. All figures in the table are in $'000. The firm's total fixed costs are $30,000. [4 marks]
| Product A | Product B | Product C | Product D | Total | |
| Sales revenue | 15 | 50 | 25 | 40 | 130 |
| Variable costs | 10 | 25 | 15 | 30 | 80 |
| Contribution per product | 5 | 25 | 10 | 10 | 50 |
Therefore, the overall profit for the business = $50,000 minus $30,000 = $20,000.
Award up to [2 marks] for calculating the contribution for the business. Apply the own-figure rule (error carried forward) as appropriate. All calculations of contribution must be correct for full marks.
Award up to a further [2 marks] for calculating the overall profit, with working out shown. Apply the own-figure rule as appropriate.
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