Contribution analysis, according to Douglas (2012) states that an analysis that is used to compare the incremental costs to the benefits of the incremental revenue. The difference between the costs and the revenue is considered the contribution margin. Douglas goes into get detail in his book how the costs are considered and any relevant costs are considered when it comes to contribution analysis. There are three categories to consider when it comes to incremental costs:
1. Present period explicit costs- This is the actual amount paid for the items or the variable in the contribution analysis
2. Opportunity costs- this includes items that cannot be sold with the present period explicit costs but have the opportunity to be sold to a third party at a lower amount or used for scrap, etc.
3. Future Costs- this includes anything that could happen in the future, including repairs, maintenance, etc. (Douglas, 2012).
Of course, the revenue is what you make when the item is sold on the market. This is used quite often in production. They are able to weight the costs versus the revenue and determine if it is worth producing the item or if they should just stop production altogether.
I actually just had to do a contribution analysis not too long ago when we were looking at buying a home. We recently moved back to the United States after my husband and decided to buy a home. However, the house market is crazy right now and we found that we could build a home for the same price of buying a home. So we then had to determine the increment costs and revenue to determine how we should proceed
With a home that was already built, the benefits, or “revenue” was that we could move in right away, would stay on budget, and would be able to live where we want to for the price we want. The costs were the costs of the home is a little elevated, there is a possibility there are hidden issues with the home.
When it comes to building a home, the revenue or “benefits” was the fact that we could have exactly what we wanted, everything is brand new and would have warranty. However, the costs was we would probably go over budget, we would have to build wherever we can afford land.
WE were able to take this analysis and make a decision based on the “costs and revenues”. However, this is something that we do everyday when buying products in stores. WE determine the costs versus the benefits. I don’t work in an industry where I really have to do this daily however, companies are definitely doing this nonstop as well to create enough profit to keep the business running. I think this is a great way to analyze if a product or item is worth producing or even buying.
Explain what is meant by “contribution analysis”. Carefully define the term and provide examples to illustrate it.
Douglas (2012) defines contribution analysis as a cost-benefit analysis method that confines costs to incremental costs while benefits are linked to incremental revenues that result from a decision being made. The purpose of contribution analysis is to measure the contribution of a decision (Douglas, 2012). The contribution of a decision can be defined “as the excess of incremental revenues over incremental costs, and it is called the contribution because it contributes to the firm’s fixed and unavoidable costs, and also to profits if total revenues are more than total costs” (Douglas, 2012, Sec. 6.1, Para. 1).
Incremental costs are the costs that change because of a decision and incremental revenues are those that are received because of the decision (Douglas, 2012). The contribution analysis can determine the contribution margin of a product by taking the price per unit of a product and subtracting the average variable cost per unit of a product (Douglas, 2012). A contribution analysis could be used by a retailer to determine if lowering the price on a product would still result in a positive contribution margin for that product.
Can you think of a recent example where you had to evaluate the incremental costs and benefits of different options in order to make a decision?
My personal example of a contribution analysis involves my pickup truck. I have a 2004 Ford F-150 with 95,000 miles on it and it has been paid off for 8 years. Before gas prices started dropping, I was looking at trading the truck in for something that got better gas mileage. When looking at the incremental costs of owning the truck, they amounted to insurance, occasional maintenance, and fuel costs. Looking at the incremental costs of getting a newer truck the incremental costs included slightly higher insurance, occasional maintenance costs, lower fuel costs, and a $400 a month car payment.
The benefits of keeping my older truck included lower insurance rates and no car payment. The benefit of getting a newer truck was a slight saving in fuel costs. When comparing the two options, it was cheaper for me to keep my truck than getting a new truck because the incremental costs of the new truck were greater than the benefit it would provide me through lower fuel costs. The difference in cost of fuel for my old truck versus the $400 a month payment for the new truck that had lower fuel costs would have resulted in a net loss of about $325 a month.
Douglas, E. (2012). Managerial Economics (1st ed.) [Electronic version]. Retrieved from https://content.ashford.edu/