According to Mott (2008, pg. 151) “the term contribution is used to describe the difference between sales value and variable costs only.” Contribution analysis is used by managers when determining whether to drop a product or not. The analysis provides a schedule of profitable products as well as those which bring losses to the business.
Imet Ltd manufactures three products, A, B and C, of which the first two have been making acceptable profits, but C has been losing money for some time and the directors are considering whether to drop it. The most recent results for the last month are as follows:
Product A B C Total
(000) (000) (000) (000)
Sales 60 120 90 270
Less Total costs 42 99 93 234
Profit or (Loss) 18 21 93 36
The directors have considered a number of possible courses of future action, but meanwhile have no new products available. Nor can they sell more of the products A or B without dropping the selling price. The immediate decision is whether to drop product C and apparently save $3,000 per month.
On investigation by the accountant, it is found that the total costs f the products includes $54,000 of fixed costs apportioned $12,000, $24,000 and 418,000 respectively. The fixed costs of $18,000 presently borne by product C will continue irrespective of whether that product is made or discontinued.
The contribution analysis is shown below.
Product A B C Total
(000) (000) (000) (000)
Sales 60 120 90 270
Less variable costs 30 75 75 180
Contribution 30 45 15 90
Less Fixed costs 54
Mott (2008) pg, 153)
The management should continue the production of product C since it provides a contribution of $15,000. However, if the contribution was negative the management should have dropped production of the product (Mott, 2008)
A budget helps the management make better decisions concerning allocation of resources. Budgets are used when applying for external sources of funds. Financial organizations consider the budgets prepared by the organization when proving loans. Well prepared budgets provide a basis of regulating performance of workers within an organization since they provide goals to be achieved within a specific period of time. Resources need to implement projects are provided for in the budget and they help the management to establish better strategies to acquire all required resources. Decisions in management are determined by the budgets prepared since most organizational decisions are based on optimal resources allocation. Budgets are important when preparing tax returns. Tax officials inspect budgets made by organizations to determine compliance with stipulation laws about taxation. Professional bodies use budgets prepared by organization when evaluating the activities being conducted by specific personnel. Managers rely entirely on budgets when making day-to-day decisions about the organization (Anthony, Hawkins and Kenneth (n.d.).
As the organization continues to grow, fixed costs reduce relative to the profits. In the short run, organizations are not able to cover up all costs. The main idea is to break-even within the short-run period. Profits are made in the long run as economies to scale provide advantage to the business. As the volume of production increases, the fixed costs remain constant and a business is able to make profits. Short run periods are meant for adapting to the environment and accumulating resources, hence profits are low (Anthony, Hawkins and Kenneth, n.d.).
Depreciation is an indirect cost which is not applicable in managerial decisions. Decisions in management require using direct costs to establish factors which can be controlled by the management. Depreciation refers to costs incurred from tear and wear of machines during the production process. These costs do not affect the pricing strategies, cost control measures and other decisions required for the success of the organization. Depreciation is a cost that does not affect the budget and cannot be used in decision making (Anthony, Hawkins and Kenneth, n.d.).
Variable costs of production and selling costs represent direct costs incurred in production of certain goods and services. The aim of a business is to make profits but there are some instances when a business is forced to forego the profits made to capture more customers or to survive specific market conditions. Special orders are made to special customers and this is done to attract more customers to the business. In the short run, a business may make orders and sell them at an aggregate price equivalent to the sum of variable costs and selling costs. A young business works to attract all potential customers but mature businesses have enough customers and they can price their products at a higher price than the costs incurred in production. When there is low demand, an organization may provide prices equivalent to the costs in order to increase demand. Stiff competition in the market can also force business enterprises to provide prices which are equivalent to the cost incurred. Market changes will make the management adopt particular pricing strategy (Anthony, Hawkins and Kenneth, n.d.).
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