Question

[accountant1]

Why contribution is more helpful in decision making than profit?

Please reply as soon as possible.

[hariharm]

The best way to explain this is to take an example:

Assume that variable costs (material and labour) are $6 per unit

Fixed costs allocated per unit $4

Total cost per unit $10


So to make a "profit", the selling price would normally be set at higher than $10 per unit.

Now let us further assume that the entity has been able to sell sufficient units at the normal selling price to recover is total fixed costs and make some profit. They receive a special order from an out-of-town buyer for a good quantity, provided they can supply the goods at $8.50 per unit.

If the use "profit" as the criterion, the entity will reject this enquiry as "unprofitable" since the price is less than total cost per unit. But if they remember that they have already recovered their fixed costs through normal sales, then they only have to recover their variable costs incurred for this special sale. Since $8.50 is higher than $6 variable cost, they will realize that each additional sold will give them additional contribution, and they might goahead with this deal.

Keep in mind that this will not work always. For example, if they have limited capacity to produce, then selling to this psecial customer may prevent normal sales to that extent. Sometimes regular customers may learn about this deal, and demand lower price. So contribution is useful, but in some circumstances.

[accountant1]

Thanks for answering my question