What is contribution? The concept of contribution is a crucial one in business. It focuses on the returns (contribution) a business makes from each unit of product sold and whether that return is enough to allow the business to make money overall after taking account of its fixed costs.
Contribution looks at the profit made on individual products. It is used in calculating how many items need to be sold to cover all the business' costs (variable and fixed).
Let's start with a really important definition & formula
Definition:
Total Contribution is the difference between Total Sales and Total Variable Costs
Formulae:
Contribution = total sales less total variable costs
Contribution per unit = selling price per unit less variable costs per unit
Total contribution can also be calculated as:
Contribution per unit x number of units sold
Let's look at a simple worked example of contribution. Here is some information about a business that just sells one product:
- Selling price per unit £30
- Variable cost per unit £18
- Contribution per unit £12 (i.e. £30 less £18)
- Units sold 15,000
Using the formulae, we can perform the following calculation:
Contribution = £180,000 (i.e. £12 x 15,000 units)
Looking at the contribution per unit above (£12), you should be able to see that it can be increased by:
- Increasing the selling price per unit - i.e. more than £30
- Lowering the variable cost per unit - i.e. less than £18
Note that the total contribution of £180,000 is not the total profit made by the business. Why? This is because we have not yet taken account of the fixed costs of the business. Let's do that now...
Imagine that, in the example above, the business has the following fixed costs:
Admin: £18,000
Marketing: £25,000
Payroll: £50,000
Other overheads: £23,000
Total: £116,000
The total fixed costs of the business are £116,000. If we take these away from the contribution (£180,000), then we can calculate the overall profit or loss of the business:
Total profit = contribution less fixed costs
Total profit = £180,000 - £116,000
= a profit of £64,000 (i.e. £180,000 less £116,000)
In the above example we calculated contribution per unit by subtracting variable cost per unit from selling price per unit.
Contribution per unit is a really useful number to have. Make sure you know the formula and are confident in calculating it!
