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Difference between contribution and profit

Business Studies Notes and

Related Essays

Approaches to Costing

 A Level/AS Level/O Level

Your Burning Questions Answered!

Discuss the different types of costing approaches and their respective advantages and disadvantages.

Explain the key differences between contribution and profit, and discuss their significance in business decision-making.

Analyze the role of costing approaches in improving efficiency and profitability within an organization.

Evaluate the factors that influence the choice of costing method in different business contexts.

Discuss the implications of using contribution and profit as performance measures for evaluating business units or operations.

Approaches to Costing: Figuring Out What Things Cost

Imagine you're running a lemonade stand. You need to know how much each cup of lemonade costs to make so you can decide how much to sell it for and how much profit you'll make. That's what costing is all about - figuring out the cost of producing something. There are different ways to do this, each with its own strengths and weaknesses:

1. Absorption Costing

-What it is: This method includes all costs, both fixed and variable, in the cost of a product.

  • -Fixed costs stay the same regardless of how much you produce (e.g., rent for your lemonade stand).
  • -Variable costs change with the amount you produce (e.g., the cost of lemons and sugar).

-Example:

  • Your lemonade stand rent is $20 a day (fixed).
  • Each cup of lemonade costs $0.50 to make (variable).
  • If you sell 20 cups, the total cost per cup is ($20 + ($0.50 x 20)) / 20 = $1.50.

-Pros: Seems simple and easy to understand.

-Cons: Can be inaccurate for pricing decisions because it doesn't account for how much you actually sell.

2. Marginal Costing

-What it is: This method only includes the variable costs in the cost of a product.

-Example:

  • Using the same example, the marginal cost of a cup of lemonade is just $0.50 (the cost of lemons and sugar).

-Pros: More accurate for pricing decisions because it focuses on the cost of producing each additional unit.

-Cons: Doesn't account for fixed costs, which are still essential to your business.

3. Activity-Based Costing (ABC)

-What it is: This method goes a step further than marginal costing by tracing costs to specific activities that create the product.

-Example:

  • Instead of just calculating the cost of lemons and sugar, ABC might consider the cost of washing the cups, preparing the lemonade, and setting up the stand.

-Pros: Provides a more detailed understanding of costs, helpful for improving efficiency.

-Cons: More complex and time-consuming than other methods.

The Difference Between Contribution and Profit

1. Contribution:

-What it is: The amount of money each product or service brings in above its variable costs.

-Formula: Contribution = Selling Price - Variable Cost

-Example: If you sell each cup of lemonade for $2, the contribution is $2 - $0.50 = $1.50.

-Importance: Contribution shows how much each product or service contributes to covering your fixed costs and generating profit.

2. Profit:

-What it is: What's left over after all your costs (fixed and variable) are covered.

-Formula: Profit = Total Revenue - Total Costs

-Example: If you sell 20 cups of lemonade, your total revenue is $40 (20 cups x $2/cup). Your total cost is $30 (fixed cost of $20 + variable cost of $10 (20 cups x $0.50)). Your profit is $10 ($40 - $30).

-Importance: Profit is the ultimate goal of any business - it's what allows the business to grow and thrive.

Real-World Examples

  • -Automakers: They use various costing methods to determine the cost of producing different car models, taking into account factors like manufacturing costs, design, and marketing.
  • -Tech companies: They use ABC costing to track the expenses associated with developing and supporting software, which can involve multiple teams, resources, and activities.
  • -Restaurants: They use cost-plus pricing, where they calculate the cost of each dish and add a markup to determine the selling price, ensuring they cover their expenses and make a profit.

Key takeaways:

  • Choosing the right costing method depends on your specific industry and business goals.
  • Contribution helps you understand how much each product or service contributes to your overall profitability.
  • Profit is the ultimate measure of success for a business.

By understanding the different costing methods and the difference between contribution and profit, businesses can make informed decisions about pricing, production, and overall business strategy.

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