situations in which contribution costing would be and would not be used

Resources → Subject Notes → Business → Lesson Plan

5.4 Costs – Approaches to Costing

Objective

To understand:

  • How costs are classified (variable, fixed, direct, indirect).
  • When to apply absorption (full) costing and when contribution (variable) costing is appropriate.
  • The limitations of each method and how they relate to break‑even and CVP analysis.

1. Cost Classification

Cost type Definition Behaviour Examples
Variable cost Changes in direct proportion to output. Per‑unit cost remains constant; total varies with volume. Direct material, direct labour, variable overhead (e.g., power per unit).
Fixed cost Remains unchanged over the relevant range of activity. Total fixed cost is constant; per‑unit cost varies with output. Factory rent, salaries of supervisors, depreciation of plant.
Direct cost Can be traced directly to a specific product or service. Usually variable, but can be fixed (e.g., a fixed salary of a dedicated technician). Direct material, direct labour.
Indirect cost Cannot be traced to a single product without allocation. Often fixed (but may contain a variable component). Factory overhead, administration costs.

2. Absorption (Full) Costing

  • Product costs: All manufacturing costs – variable + fixed – are treated as inventoriable.
  • Fixed manufacturing overhead is allocated to each unit produced using a chosen allocation base (e.g., machine‑hours, labour‑hours, or normal capacity). The base must be consistent with the cost‑driver of the overhead.
  • Formula for unit product cost:
    Unit product cost = Variable manufacturing cost per unit + (Total fixed manufacturing overhead ÷ Allocation base used) × (Base per unit)
  • Fixed selling & administrative costs and any other period costs are expensed in the period incurred.
  • Required by IFRS, UK GAAP and most tax regimes for inventory valuation.

3. Contribution (Variable) Costing

  • Product costs: Only variable manufacturing costs are inventoriable.
  • All fixed manufacturing overhead (and fixed selling & admin costs) are treated as period costs and written off in the period incurred.
  • Key formulas:
    Contribution = Sales revenue – Variable costs
    Contribution per unit = Selling price per unit – Variable cost per unit
    Contribution margin ratio = (Contribution ÷ Sales revenue) × 100 %
  • Provides the basis for short‑term decision making and CVP analysis.

4. When to Use Each Approach

4.1 Contribution Costing – Situations Where It Is Preferred

  • Short‑term decisions that depend on changes in volume (pricing, make‑or‑buy, special orders, product‑mix optimisation).
  • Cost‑Volume‑Profit (CVP) and break‑even analysis – the contribution margin directly links revenue to fixed‑cost coverage.
  • Internal performance evaluation of product lines, departments or sales territories where fixed costs are common‑size.
  • Budgeting & forecasting when the focus is on variable‑cost behaviour.
  • Management reports that need to show the impact of a change in output on profit.

4.2 Absorption Costing – Situations Where It Must Be Used

  • External financial reporting – statutory accounts must value inventory on an absorption basis.
  • Tax returns – most jurisdictions require absorption costing for inventory valuation.
  • Long‑term strategic planning (capacity expansion, capital investment, product‑development) where the full cost of production must be considered.
  • Pricing of long‑term contracts that must recover both variable and fixed manufacturing costs.
  • When fixed costs form a large proportion of total cost – ignoring them would give a misleading picture of profitability.

5. Limitations of Each Method

Method Key Limitation
Contribution (Variable) Costing Can under‑state product cost when fixed manufacturing overhead is significant; not acceptable for external reporting or tax; may lead to pricing errors for long‑term contracts if fixed costs are ignored.
Absorption (Full) Costing Requires allocation of fixed overheads – the choice of allocation base can be arbitrary and may distort product profitability; can encourage over‑production to allocate more fixed cost to inventory, inflating reported profit; less useful for short‑term decisions because fixed costs are “hidden” in product cost.

6. Break‑Even and CVP Analysis (Using Contribution Costing)

Break‑even point (units) = Fixed costs ÷ Contribution per unit

Break‑even sales (£) = Fixed costs ÷ Contribution margin ratio

6.1 Worked Example – Contribution Costing

  1. Selling price per unit: £120
  2. Variable manufacturing cost per unit: £50
  3. Variable selling & admin cost per unit: £10
  4. Fixed manufacturing overhead (per month): £30,000
  5. Fixed selling & admin overhead (per month): £15,000

Contribution per unit = £120 – (£50 + £10) = £60

Total fixed costs = £30,000 + £15,000 = £45,000

Break‑even units = £45,000 ÷ £60 = 750 units

Break‑even sales = 750 × £120 = £90,000

6.2 Worked Example – Absorption Costing (Same data, 2,000 units produced)

  • Fixed manufacturing overhead allocation base: machine‑hours. Assume 2,000 machine‑hours → £30,000 ÷ 2,000 = £15 per unit.
  • Unit product cost = Variable manufacturing (£50) + Fixed overhead allocation (£15) = £65.
  • Cost of goods sold (COGS) = 2,000 × £65 = £130,000.
  • Sales revenue = 2,000 × £120 = £240,000.
  • Gross profit = £240,000 – £130,000 = £110,000.
  • Net profit after fixed selling & admin (£15,000) = £95,000.

7. Comparison of Absorption and Contribution Costing

Aspect Absorption (Full) Costing Contribution (Variable) Costing
Cost classification All manufacturing costs (variable + fixed) are product costs. Only variable manufacturing costs are product costs; all fixed costs are period costs.
Inventory valuation Includes fixed manufacturing overhead – higher inventory values. Excludes fixed manufacturing overhead – lower inventory values.
Profit measurement Gross profit (sales – total product cost); required for statutory accounts. Contribution margin (sales – variable costs); useful for short‑term decisions.
Break‑even analysis Fixed overhead must first be allocated to units before calculating break‑even. Directly uses contribution per unit (fixed costs ÷ contribution per unit).
Decision relevance Shows total cost recovery but can mask volume effects. Highlights the effect of volume changes on profit.
Typical uses External reporting, tax, long‑term planning, pricing of contracts. CVP analysis, short‑term pricing, make‑or‑buy, special orders, internal performance reports.
Limitations Arbitrary overhead allocation; may encourage over‑production; less useful for short‑term decisions. Ignores fixed costs; not acceptable for external reporting; can mislead when fixed costs are large.

8. Summary Checklist

  • Identify each cost as variable/fixed and direct/indirect before deciding on a costing method.
  • Use **contribution costing** for:
    • Short‑term, volume‑related decisions.
    • CVP and break‑even analysis.
    • Internal performance evaluation where fixed costs are common.
  • Use **absorption costing** for:
    • External financial statements and tax returns.
    • Long‑term strategic planning and contract pricing.
    • Any situation where full cost recovery is required.
  • Remember the key formulas:
    • Contribution per unit = Selling price – Variable cost per unit
    • Break‑even units = Fixed costs ÷ Contribution per unit
    • Absorption unit cost = Variable manufacturing cost + (Fixed manufacturing overhead ÷ Allocation base) × (Base per unit)
  • Be aware of the limitations of each method and choose the one that best matches the decision context.
Suggested flow‑chart: “Decision required?” → “Short‑term/volume?” → “Use Contribution Costing” → “Long‑term or external reporting?” → “Use Absorption Costing”.

Create an account or Login to take a Quiz

27 views
0 improvement suggestions

Log in to suggest improvements to this note.