Occasionally a company is confronted with unplanned events which call for the use of decision-making tools beyond those found in the basic accounting methods.
In today’s manufacturing context some companys are more and more likely to entertain the potential of spur of the moment opportunities and vehicles to achieve increased revenues. By the very nature of such decisions, they do not have the luxury of regular costing information and additional effort is needed to improve understanding of potential costs. A useful method which may improve the understanding of these costs is called contribution analysis.
Contribution analysis addresses the problem of identifying soft, or overhead costs associated with varying production projects. Generally, contribution analysis aids a company by accounting for all known fixed, direct and variable costs and then subtracting that amount from revenues. The remainder is viewed as the volume of other costs which, though hard to pin down, actually contribute to production.p
To further hone in on these costs, some firms may even include some marketing costs; advertising, trade and consumer promotions, as direct costs. In this method , indirect costs consists of revenue minus direct costs. Contribution analysis is derived from other accounting priciples aimed at more correctly identifying costs such as Activity Based Costing(ABC).
For example - a large firm might employ contribution analysis to help in decisions on pricing, or how to get the most profit from an individual project. Such information is valuable if a firm were to consider a contract offer for a special order. The aim of the contribution analysis is to be to base the company's pricing on a contribution margin calculated as described below
Contribution Margin Per Unit x Units Sold = Product’s Contribution to Profit
And using those results to arrive at the desired price –
Price - Variable Costs Per Unit = Contribution Margin Per Unit
On an individual special order project a company's product contribution to profit may also be calculated as shown below:
Products Contribution to Profit = Contribution Margin Per Unit x Units Sold