Contribution Concept

The idea is simple and many of us even know this. Consider you are starting a taxi service. You have identified that taxi service incur only three expenses

1) investment you did for buying the car (2lac)

2) salary of the driver (5000 per month)

3) petrol as you consume it (Rs8 per km).

1^st is a one time investment 2^nd is same every month (say: what ever distance you run). 3^rd is variable cost. You are planning to run this car for 5 yrs so your total investment is 40k per yr+5*12K(approx)=Rs 1lac this 1lac is the total you have to spend every year even if you run the business or not.

Say this year you got a contract to run 40k kms for a company which will pay for the petrol consumption so you have to decide on how much you should charge them. Earlier days what you did is you find your expense as 1lac/40k = 2.5Rs per km so decide to charge 3Rs per km (20% profit) but it wont work because here this contractor wont agree saying that this is high price. Why? Because he knows from the market that the max capacity the car can run is 60k kms and he is not responsible for the car not running to its full capacity (60k) so he won’t agree to this high price. So we will agree for a price 1lac/60k = 1.66Rs per km +20% profit = 2Rs and we will get the contract. And this is true to every industry unless it has got some monopoly in technology

So here you are considering the contribution concept in deciding the cost

Total cost(TC) = Fixed cost(F.C)+ Variable Cost (V.C)

Sales- VC = contribution (C)

C- FC = Profit

This contribution concept is important when you run the breakeven analysis because if you know the contribution per unit sold you can find out how many number of units you have to sell in order to breakeven. You can also use this to identify whether you have to invest in capacity expansion or in cost reduction to improve contribution etc.

As published on 31/01/09