contribution costing as a means to help make special order decisions

5.4 Costs – Uses of Cost Information

5.4.1 Why Cost Information Matters

• Cost data enable managers to answer “what‑if” questions and to choose the most profitable course of action.
• In the Cambridge 9609 syllabus cost information is the basis for:
  • Pricing decisions
  • Product‑mix (resource‑allocation) decisions
  • Make‑or‑buy decisions
  • Stop‑loss / continue‑or‑discontinue decisions
  • Special‑order decisions
  • Performance monitoring (budgeting & variance analysis)
  • Break‑even analysis
• Full (absorption) costing provides the **total unit cost** required for long‑run pricing, external reporting and inventory valuation, whereas contribution costing isolates the **incremental** costs that matter for short‑run decisions.

5.4.2 Approaches to Costing

Aspect	Contribution (Marginal) Costing	Full (Absorption) Costing
Treatment of fixed production costs	Period costs – charged to the income statement in the period incurred	Product costs – allocated to each unit and carried in inventory
Variable costs	Assigned to products (direct material, direct labour, variable overhead)	Same treatment as contribution costing
Primary purpose	Analyse incremental (relevant) costs & contribution margin	Determine total cost per unit for external reporting, inventory valuation and long‑run pricing
Decision‑making usefulness	Short‑run decisions where fixed costs are sunk	Long‑run pricing, profitability reporting, statutory accounts
Limitations	Ignores fixed‑cost recovery; can mislead when capacity is scarce	Blurs the impact of variable costs on incremental decisions

Numerical illustration of a full‑cost unit price

Assume the following data for Product X:

Cost element	Per unit (£)
Direct material	12
Direct labour	8
Variable overhead	5
Fixed production overhead (allocated)	10

Total absorption cost per unit = 12 + 8 + 5 + 10 = £35

5.4.3 Relevant vs. Irrelevant Costs

Relevant costs are those that will change as a result of the decision:

• Variable costs directly tied to the activity.
• Any additional fixed costs that arise only if the decision is taken (e.g., extra set‑up, overtime).
• Opportunity cost of using a scarce resource in an alternative way.

Irrelevant (sunk) costs have already been incurred and cannot be altered:

• Allocated fixed production overhead already absorbed in inventory.
• Depreciation of existing plant.
• Past marketing expenses.

Decision analysis step‑by‑step:

1. List **all** costs associated with the alternative.
2. Cross‑out any sunk costs.
3. The remaining items form the relevant‑cost checklist.

5.4.4 Opportunity Cost & Capacity Constraints

• Opportunity cost = contribution that could be earned from the next best use of a limited resource.
• When capacity is fully utilised, accepting a new order means giving up the contribution from the displaced activity.
• Decision rule: accept only if the net contribution from the new order exceeds the opportunity cost.

5.4.5 Using Cost Information for Specific Decisions

5.4.5.1 Pricing Decisions

Target‑price method (short‑run):

Target price = Variable cost per unit + Desired contribution per unit

Example

Item	£
Variable cost per unit	45
Desired contribution per unit (to achieve £180,000 profit on 20,000 units)	9

Target price = 45 + 9 = **£54** per unit. The firm then checks whether £54 is acceptable in the market.

5.4.5.2 Product‑Mix (Resource‑Allocation) Decisions

When a limiting factor (e.g., machine hours) is scarce, calculate contribution per unit of the limiting factor and rank products.

Product	Contribution per unit (£)	Limiting factor used per unit	Contribution per limiting factor (£)
A	30	2 hrs	15
B	20	1 hr	20
C	25	3 hrs	8.33

With 1,200 machine‑hours available, the optimal mix is:

1. Produce 1,200 units of B (uses 1,200 hrs, contribution = 1,200 × £20 = £24,000).
2. No capacity left for A or C, so they are not produced.

5.4.5.3 Make‑or‑Buy Decisions

Compare the relevant cost of producing in‑house with the external purchase price.

Relevant cost of making = Variable cost per unit + any additional fixed cost that would be incurred.

Example

• Variable cost per unit = £18
• Extra set‑up cost if produced internally = £2,000 (fixed, but only if the decision is taken)
• Order quantity = 5,000 units

Relevant cost of making = (18 × 5,000) + 2,000 = £92,000.

External supplier quote = £19 per unit → £95,000 for 5,000 units.

Since £92,000 < £95,000, the firm should **make** the part.

5.4.5.4 Stop‑Loss / Continue‑or‑Discontinue Decisions

Assess whether the contribution from continuing the product exceeds the avoidable costs that would be saved by dropping it.

Example

Item	£ per year
Sales revenue (2,000 units @ £50)	100,000
Variable cost (materials & labour)	60,000
Contribution	40,000
Avoidable fixed costs (e.g., special advertising, extra supervision)	30,000
Unavoidable fixed costs (already sunk)	20,000

Net benefit of continuing = Contribution – Avoidable fixed = 40,000 – 30,000 = **£10,000** (positive). Therefore the product should be **continued**.

5.4.5.5 Special‑Order Decisions (Contribution‑Costing Approach)

1. Identify order size and special selling price.
2. Determine the variable cost per unit for the product.
3. Calculate contribution per unit: Special price – Variable cost.
4. Multiply by order quantity to obtain total contribution.
5. Deduct any extra costs directly attributable to the order (set‑up, freight, special packaging).
6. Consider capacity and opportunity cost – would the order displace a higher‑margin sale?
7. Decision rule: accept if net contribution is positive **and** the opportunity cost is not higher.

Illustrative Example

Cost Item	Per Unit (£)	Total (£)
Direct materials	30	300,000
Direct labour	20	200,000
Variable overhead	10	100,000
Total variable cost per unit	60
Fixed production overhead	—	150,000
Fixed selling & admin overhead	—	50,000

Special order: 2,000 units @ £85 each. Extra set‑up cost = £5,000.

• Contribution per unit = 85 – 60 = £25
• Total contribution = 25 × 2,000 = £50,000
• Net contribution = 50,000 – 5,000 = **£45,000** (positive)

Capacity is sufficient, so the order should be **accepted**.

5.4.5.6 Performance Monitoring (Budgeting & Variance Analysis)

Contribution data are used to set short‑term budgets and to measure performance.

• Sales budget: forecast sales volume × selling price.
• Production budget: required output to meet sales plus desired closing stock.
• Contribution variance:
  $$\text{Contribution Variance} = (\text{Actual contribution} - \text{Budgeted contribution})$$
  or broken down into:
  • Sales‑volume variance = (Actual units – Budgeted units) × Budgeted contribution per unit
  • Price‑variance = (Actual price – Budgeted price) × Actual units
  • Cost‑variance = (Actual variable cost – Budgeted variable cost) × Actual units

Sample variance calculation

	Budgeted	Actual
Units sold	10,000	9,500
Selling price per unit (£)	120	118
Variable cost per unit (£)	60	62

Budgeted contribution per unit = 120 – 60 = £60
Actual contribution per unit = 118 – 62 = £56

Contribution variance = (9,500 × 56) – (10,000 × 60) = £532,000 – £600,000 = **‑£68,000** (unfavourable). The unfavourable variance can be further split into volume, price and cost components for detailed analysis.

5.4.5.7 Break‑Even Analysis (Link to Contribution)

Break‑even point (units) = Total fixed costs ÷ Contribution per unit.

Example using data from the special‑order section

• Total fixed costs (production + selling & admin) = £150,000 + £50,000 = £200,000
• Contribution per unit (standard sales) = Selling price £120 – Variable cost £60 = £60

Break‑even volume = 200,000 ÷ 60 ≈ **3,334 units**.

If the firm sells more than 3,334 units it makes a profit; fewer units result in a loss. The same contribution figure (£60) is also the basis for the pricing, product‑mix and special‑order calculations above, showing the cohesion of the cost information.

Summary

• Full (absorption) costing supplies the total unit cost needed for external reporting and long‑run pricing.
• Contribution costing isolates the incremental costs and revenue that drive short‑run decisions.
• Always separate **relevant** from **irrelevant** (sunk) costs; include opportunity costs when capacity is limited.
• Apply the appropriate framework – pricing, product‑mix, make‑or‑buy, stop‑loss, special‑order – using clear numerical calculations.
• Use contribution data for budgeting, variance analysis and break‑even planning, ensuring a consistent approach across all managerial decisions.