Costing → the process of identifying and calculating the costs of producing a product or providing a service
→ Two important approaches → full costing and contribution costing
→ The main difference → full costing includes both fixed and variable costs in the cost of a product, while contribution costing focuses mainly on variable costs and the contribution made towards fixed costs and profit
Full Costing
→ Full costing → a costing method that calculates the total cost of producing a product by including both direct and indirect costs
→ Full costing includes → variable costs + an allocated share of fixed/overhead costs
→ Example:
→ Direct materials = ₹100 per unit
→ Direct labour = ₹50 per unit
→ Allocated overheads = ₹30 per unit
→ Full cost = ₹180 per unit
→ The business can then add a profit margin to the full cost → to determine a selling price
→ Formula:
→ Full cost per unit = Total production costs ÷ Number of units produced
Uses of Full Costing
→ Setting prices → helps a business calculate the total cost of producing a product → price can then be set above this cost to generate profit
→ Measuring product profitability → helps determine whether the selling price covers the full cost of production
→ Cost control → managers can identify the different costs associated with production
→ Long-term decision-making → useful when the business needs to ensure that prices cover both variable and fixed costs over time
→ Example: A manufacturer calculates the full cost of a product as ₹500 → sells it for ₹650 → the ₹150 difference contributes towards profit
→ Analysis: full costing → ensures fixed and variable costs are considered → reduces the risk of setting a price that appears profitable but fails to cover total costs
Limitations of Full Costing
→ Allocation of overheads can be subjective → indirect costs such as rent, electricity and administration costs must be allocated between products
→ Different allocation methods → can produce different unit costs
→ Example: A factory produces two products → deciding how much factory rent should be allocated to each product may be difficult
→ Full costing may be less useful for short-term decisions → because fixed costs may not change when output changes
→ Analysis: allocating fixed costs to individual products → may make a product appear unprofitable → even though producing an additional unit would still generate a positive contribution
→ Evaluation: full costing is more useful for long-term pricing decisions → where the business must eventually recover its fixed costs
Contribution Costing
→ Contribution costing → a method that focuses on the contribution made by each unit towards fixed costs and profit
→ It considers variable costs directly when calculating contribution
→ Formula:
→ Contribution per unit = Selling price per unit − Variable cost per unit
→ Total contribution = Total sales revenue − Total variable costs
→ Example:
→ Selling price = ₹500
→ Variable cost = ₹300
→ Contribution = ₹500 − ₹300 = ₹200 per unit
→ Each unit therefore contributes ₹200 towards → fixed costs and then profit
Nature of Contribution Costing
→ Contribution is not the same as profit
→ Contribution is generated before fixed costs are deducted
→ Formula:
→ Profit = Total contribution − Total fixed costs
→ Example:
→ Contribution = ₹20 lakh
→ Fixed costs = ₹15 lakh
→ Profit = ₹5 lakh
→ If contribution is less than fixed costs → the business makes a loss
→ If contribution equals fixed costs → the business makes zero profit / breaks even
→ If contribution exceeds fixed costs → the business makes a profit
Contribution and Profit – Difference
→ Contribution → sales revenue − variable costs
→ Profit → contribution − fixed costs
→ Contribution shows → how much is available to cover fixed costs and then generate profit
→ Profit shows → the amount remaining after all relevant costs have been deducted
→ Example:
→ Sales revenue = ₹1,000,000
→ Variable costs = ₹600,000
→ Contribution = ₹400,000
→ Fixed costs = ₹300,000
→ Profit = ₹100,000
→ Therefore → contribution can be positive even when the business is making a loss
Uses of Contribution Costing
→ Short-term pricing decisions → useful when deciding whether to accept a special order at a price below the normal full cost
→ Make-or-buy decisions → helps compare the relevant variable costs of producing a product with the cost of purchasing it
→ Product decisions → helps identify products that make positive contributions towards fixed costs
→ Special orders → useful when a business has spare capacity and receives an additional order
→ Break-even analysis → contribution is used to calculate the break-even point
→ Example: A business has spare production capacity and receives an order at ₹400 per unit → variable cost is ₹250 → contribution is ₹150 per unit → the order may be worthwhile if it does not create additional fixed costs or affect normal sales
→ Analysis: positive contribution → additional revenue exceeds additional variable costs → contributes towards fixed costs → may increase total profit
Limitations of Contribution Costing
→ Contribution costing does not allocate fixed costs to individual products
→ This can make it difficult to determine the long-term profitability of individual products
→ It assumes that variable costs can be accurately identified → but some costs may be partly fixed and partly variable
→ It is more useful in the short run → because fixed costs may change over longer periods
→ It may encourage managers to focus too heavily on products with high contribution → while ignoring the need to cover total fixed costs
→ Example: Product A has a contribution of ₹200 per unit but Product B has a contribution of only ₹100 → Product A may appear better → but Product A may also require significantly more fixed resources
→ Analysis: relying only on contribution → may result in decisions that increase short-term contribution but reduce long-term profitability
→ Evaluation: contribution costing should therefore be used alongside other financial and non-financial information
When Contribution Costing Would Be Used
→ Short-term decisions → when fixed costs are unlikely to change
→ Special orders → particularly when the business has spare capacity
→ Temporary pricing decisions → when the business needs to decide whether a lower price can still cover variable costs
→ Make-or-buy decisions → where relevant variable costs can be compared
→ Choosing between products in the short run → particularly when there is a limiting factor
→ Example: A hotel has empty rooms during the off-season → accepting a booking at a lower price may still be worthwhile if the price exceeds the additional variable costs
→ Analysis: spare capacity → fixed costs already exist → additional sales generate positive contribution → total profit may increase
When Contribution Costing Would Not Be Used
→ Long-term pricing decisions → because the business eventually needs to recover fixed costs
→ Long-term investment decisions → because fixed costs and capacity may change
→ Assessing overall business profitability → because contribution does not deduct fixed costs
→ When capacity is limited → contribution per unit of the scarce resource may need to be considered rather than contribution per unit alone
→ Example: If a business is operating at full capacity, accepting a low-price special order may displace a more profitable normal order
→ Analysis: limited capacity → opportunity cost becomes important → contribution costing based only on the additional order may lead to an incorrect decision
Full Costing vs Contribution Costing
| Full Costing | Contribution Costing |
|---|---|
| Includes variable and allocated fixed costs | Focuses on variable costs |
| Calculates full cost per unit | Calculates contribution per unit |
| Useful for long-term pricing | Useful for short-term decisions |
| Allocates overheads to products | Does not allocate fixed costs to individual products |
| Helps assess long-term profitability | Helps assess short-term contribution |
| Overhead allocation can be subjective | Simpler when variable costs are identifiable |
Analysis
→ full costing → includes fixed and variable costs → more complete picture of long-term costs → useful for long-term pricing
→ contribution costing → focuses on variable costs → simpler and useful for short-term decisions → helps managers assess the effect of additional output or sales
→ positive contribution → sales revenue exceeds variable costs → some fixed costs can be covered → potential increase in profit
→ full costing → allocated overheads included → product may appear unprofitable → but contribution may still be positive → product could be worth continuing in the short term
→ contribution costing → does not allocate fixed costs → avoids potentially subjective overhead allocation → but provides less information about long-term total costs
Evaluation
→ Full costing is generally more appropriate for long-term decisions → because all costs eventually need to be covered if the business is to remain profitable
→ Contribution costing is generally more appropriate for short-term decisions → particularly where fixed costs are unchanged and the business has spare capacity
→ Neither method should be used in isolation → managers should also consider demand, competition, capacity, opportunity cost and strategic objectives
→ Overall → full costing provides a broader view of the total cost and long-term profitability of a product, while contribution costing provides a useful measure for short-term decision-making by showing how sales contribute towards fixed costs and profit.