The Significance of Contribution in Pricing Decisions
On the basis that contribution is not the same as profit, then why is it useful in pricing decisions?
The usefulness of the contribution calculation is that it can aid when deciding on the price at which products could be sold.
Consider the following scenario:
A company has budgeting its income and expenditure for the forthcoming year to be
Income £500,000 (made up of sales of 10,000 chairs at £50 each)
Direct or marginal costs
Wood £100,000 (10,000 chairs at £19 each)
Direct labour £50,000 (10,000 items at £5 per item)
Glue £20,000 (10,000 chairs at £2 each)
Varnish £20,000 (10,000 chairs at £2 each)
Total direct or marginal costs = £190,000 (£19 each)
Indirect or overhead costs
Rent £15,000 per annum
Marketing and selling £50,000 per annum
Administrative salaries £30,000 per annum
Rates £15,000 per annum
Director’s salaries £50,000 per annum
Total indirect or overhead costs = £160,000 (£16 each)
Some facts about the above data.
The budgeted contribution would be £500,000 less £190,000 = £310,000
The estimated profit would be £500,000 less 190,000 less £160,000 = £150,000
The contribution per chair would be £310,000 divided by 10,000 = £31 each
The budgeted profit per chair would be £150,000 divided by 10,000 = £15 each
The total of direct and indirect costs attributable to each chair is £50 less £15 = £35
During the year, the company received an unanticipated offer to make 1,000 chairs. This would be in addition to the 10,000 chairs it was already in the process of making in line with its budgeted activity.
The customer has offered a total of £25,000 for the 1,000 additional chairs.
Should the chair manufacturer accept or reject the offer and if they should accept it, what price should they be willing to sell them at?
If the decision was based purely on a profitability perspective, the answer would be no. Each chair incurs total costs of £35 and therefore an offer of £25 would effectively cost the company £10 for each item it made and sold at this price.
This might well be the wrong decision though.
For each £25 received for a chair the direct or marginal costs incurred in manufacturing that chair is only £19. Each sale therefore results in a contribution of £6.