<CONTRIBUTION COSTING (HL)>

<ABSORPTION COSTING (HL)>

--INTRO: COSTING METHODS--

COSTING METHODS are just different ways to answer the same question:

"How much of our total costs need to be assigned to the production of one unit of product X?"

Sounds simple, right! When we were tackling costs back in UNIT 3.3 we saw that TOTAL COST (TC) = to TFC + TVC so the total cost per unit (AC) is AC = TC/Q this is perfectly fine IF YOU ONLY PRODUCE A SINGLE PRODUCT, however WHEN YOU PRODUCE MORE THAN ONE PRODUCT, things get a bit tricky as:
- - - Different products are made in different quantities.
    - They use different amounts of variable costs (e.g. raw materials...)
    - They also use fixed resources differently (e.g. factory space...)
So now the question becomes:
"How much of our costs should be assigned to making one unit of Product X, and how much to making one unit of Product Y?"
It’s no longer fair to just divide total costs by the total number of units. Each product uses resources in its own unique way — and costing methods help us figure out how much each product truly costs to make.

'ABSORPTION'

“Let’s include ALL costs — both variable and fixed — into the cost of each unit produced!"

This costing method is called ABSORPTION COSTING (also called full costing as it works out the 'full-cost' of each unit) is based on the premise that each unit of output "absorbs" a portion of all the costs involved in making it.

--HOW IT WORKS?--

VARIABLE COSTS (like materials, electricity, labor) are directly traced to each product.

FIXED COSTS (like rent, supervisors salaries) are then SPREAD ACROSS all units produced, using some form of common base, such as: Labour hours, machine hours, or units produced. So, Product X gets its fair share of fixed costs, based on how much it "used up" the factory’s resources.

As we can see from the worked examples above every unit absorbs a share of fixed costs — $4 in this case — regardless of whether it used more factory time, space, or resources. That’s the limitation, but it’s simple and commonly used for financial statements.

'CONTRIBUTION'

“Let’s assign only the variable costs to each unit, and treat fixed costs as a lump sum that we don't divide up per product!"

This costing method is called CONTRIBUTION COSTING It focuses on how much each product “contributes” to covering fixed costs and generating profit, as when ONLY VARIABLE COSTS ARE DEDUCTED from REVENUE, the remainder, 'CONTRIBUTES' to COVERING FIXED COSTS and/or CREATE PROFIT

Therefore,

CONTRIBUTION = REVENUE - VARIABLE COSTS
TOTAL CONTRIBUTION = the total contribution of all units sold, therefore...
TOTAL CONTRIBUTION > FIXED COSTS, then the SURPLUS is PROFIT.
TOTAL CONTRIBUTION < FIXED COSTS, then their is A LOSS.

--HOW IT WORKS?--

VARIABLE COSTS (like materials, electricity, labor...) are directly traced to each product.

FIXED COSTS (like rent, supervisors salaries) are NOT DIVIDED among products

Contribution costing answers the question by showing how much each product helps to cover fixed costs and make profit — rather than trying to assign fixed costs per unit.

It’s especially useful when:

You're choosing which products to keep or drop
You're working in a short-term decision context
You want to analyze profitability without distortion from fixed cost allocations

"Why would you calculate costs using only variable costs?"

Because averaging out fixed costs isn't always fair and some products that use a lot of them will look less expensive whilst other products that use a lesser amount will look more expensive. Therefore using only variable costs will give the operations manager a better idea of which product has the lower cost per unit and is more profitable.
It's perfect for working out which product is more profitable and whether they shoul dmake more of one and less of another.

--DISCUSSION TASK--

As the operations manager of a school you are tasked with planning production and you wish to decide whether to have more PE classes or more ICT classes based on their respective cost per class.

Questions that needed answering were as follows

"What is the cost of a single lesson at this school?"

"That's too broad, we have so many different subject teachers, so costs differ!"

"Is it costlier to host a PE class or an ICT class?"

"Hmm!!!, teacher salaries are equal, so the same cost per class right?"

"If we just used the variable cost of electricity usage, which is the costliest?"

"In terms of electricity usage I think the ICT classes will cost more, right?"

What if there are more ICT classes per week than PE?

"It makes no difference as we are working out cost on a 'per-class' basis!"

What if the ICT classes are able to get some economies of scale?

"Then their average variable costs will fall, maybe below P.E.?"

"If we just used the fixed cost of rental space, which is the costliest?"

"In terms of the cost of rental space, I think P.E. classes will cost more, right?"

"What if there are twice as many PE classes as ICT ones per week?"

"With more PE classes, the class will"

"Is the average cost of rental space the same for both teachers?"

"In terms of the cost of rental space, clearly the PE class will be more on average"

"What if there are twice as many ICT classes as PE ones?"

"In this case, "

"Should we have more PE or ICT classes at school?

You should now realise that the answer to the original question about "How much does it cost to make one unit of your product?" changes depending on three factors:

1) whether you include ONLY variable costs,

2) whether you include variable AND fixed costs,

3) how many units you spread those costs across

and surprise, surprise there are distinct methods; CONTRIBUTION COSTING and ABSORPTION COSTING, which we will now look at in turn.

Whether you include only variable costs (contribution)

Or include all costs (absorption)

And how many units (students) you spread those costs across

"A good can have a positive contribution per unit but makes no profit, so should a firm stop the production of a good that contributes no profits?"

As noted above positive contribution can be used to pay off FIXED/INDIRECT COSTS which MUST BE PAID REGARDLESS of whether the business is making a profit or loss, as such even though the unit isn't making a profit it is making a contribution to the reduction of these indirect costs. Let's look at two scenarios in which contribution costing is used to make decisions.

--LIMITATIONS OF CONTRIBUTION COSTING--

⚠️IGNORES FIXED COSTS⚠️

⚠️ 2. Not Suitable for External Reporting

Example:

A publicly listed electronics firm uses contribution costing internally to assess which gadgets generate the most margin. However, when it submits its accounts to auditors, it must use absorption costing, allocating fixed costs across all units, as per financial reporting standards.

This creates a mismatch between internal insights and external obligations.

⚠️ 3. Risk of Misusing for Strategic Decisions

Example:

A clothing company uses contribution costing to assess which product lines to invest in long term. It decides to expand a low-variable-cost T-shirt line based solely on its high contribution margin. But they fail to account for rising fixed costs (e.g. needing more warehouse space and staff), leading to lower-than-expected profits after expansion.

⚠️ 4. Overemphasis on Variable Costs

Example:

A video game company uses contribution costing to analyze profitability. Their games have very low variable costs (downloads cost virtually nothing), but high fixed costs (developers, designers, servers). Contribution costing shows great margins, but doesn’t highlight how many units need to be sold to break even.

Management may overestimate success without realizing the weight of fixed costs.

⚠️ 5. Assumes Linear Cost Behavior

Example:

A school’s cafeteria uses contribution costing to decide meal pricing. It assumes food costs are variable and rent is fixed. But if the school rolls out more hot lunches, it needs to hire an extra chef – a step cost not reflected in the model.

This results in underestimating costs at higher output levels.

⚠️ 6. Can Lead to Misleading Profitability Judgments

Example:

A manufacturer sees that Product X has a high contribution per unit, so they ramp up production. However, when total profits fall, they realize that Product X required extra customer support and after-sales service — hidden fixed costs not considered in the contribution costing.

The product wasn’t truly profitable after all.

--WHEN TO USE CONTRIBUTION COSTING--

--WHEN NOT TO USE CONTRIBUTION COSTING--

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