Understanding Contribution to Cover Fixed Costs
- Jojo is running a small café.
- Jojo sells each cup of coffee for \$5, and it costs \$2 to make one cup.
- The difference between these two amounts, \$3, is what helps Jojo pay for fixed costs, like rent and salaries.
This difference is called contribution.
Contribution
Contribution is the amount of money left after subtracting variable costs from sales revenue. It helps cover fixed costs and, once those are covered, contributes to profit.
Contribution Per Unit
Contribution per unit
Contribution per unit tells you how much each unit sold contributes to covering fixed costs.
Contribution per unit is a key metric for understanding how much each sale helps your business move closer to profitability.
Formula
The formula for contribution per unit is:
$$\text{Contribution per Unit} = \text{Selling Price per Unit} - \text{Variable Cost per Unit}$$
- Suppose you sell a product for \$20, and the variable cost per unit is \$8. The contribution per unit would be:$$\text{Contribution per Unit} = \$20 - \$8 = \$12$$
- This means each unit sold contributes \$12 towards covering fixed costs.
Think of contribution per unit as the "leftover" money from each sale that helps cover your fixed expenses.
Total Contribution
While contribution per unit focuses on a single unit, total contribution looks at the overall contribution from all units sold.
Formula
The formula for total contribution is:
$$\text{Total Contribution} = \text{Contribution per Unit} \times \text{Quantity Sold}$$
- Using the previous example, if you sell 500 units, the total contribution would be: $$\text{Total Contribution} = \$12 \times 500 = \$6,000$$
- This \$6,000 goes towards covering fixed costs.
- Any amount beyond the fixed costs becomes profit.
Why Contribution Matters
- Covering Fixed Costs: Contribution helps determine how many units need to be sold to cover fixed costs.
- Profit Calculation: Once fixed costs are covered, contribution directly adds to profit.
- Pricing Decisions: Understanding contribution helps set prices that cover costs and generate profit.
- Break-Even Analysis: Contribution is essential for calculating the break-even point, where total revenue equals total costs.
- Total contribution is not the same as profit.
- It first covers fixed costs, and only the remaining amount (if any) becomes profit.
Using Contribution to Make Decisions
1. Break-Even Analysis (discussed in the next sections)
Contribution helps calculate the break-even point, the number of units that must be sold to cover all costs.
2. Assessing Profitability
Contribution helps evaluate whether a product or service is profitable.
If a product has a low contribution per unit, the business may need to increase the selling price, reduce variable costs, or discontinue the product.
3. Decision-Making
- Contribution analysis aids in making strategic decisions, such as:
- Introducing New Products: Will the contribution cover additional fixed costs?
- Pricing Strategies: How will changes in price affect contribution and profitability?
- Cost Management: Can variable costs be reduced to increase contribution?
- Contribution gives managers a numerical framework for deciding whether a product is worth producing in the short term.
- It’s objective, measurable, and grounded in accounting data.
- The Knower: Managers interpret those numbers through their own perspectives, values, and responsibilities.
- For example:
- An operational manager may use contribution to justify cost-cutting that boosts margins.
- A strategic leader may reject those cuts if they harm brand reputation, long-term growth, or violate ethical standards (e.g., cutting labour costs by underpaying workers).
- The tension is that contribution shows what is financially viable, but the knower decides what is acceptable or sustainable.
- Knowledge alone doesn’t dictate the decision, interpretation does.
- What is the difference between contribution per unit and total contribution?
- How does contribution help in calculating the break-even point?
- Why is it important to distinguish between contribution and profit?
