Financial Management of a Small Handicraft Business (Oxfam, 1988, 43 p.): II. Pricing: II.3. Contribution analysis

Financial Management of a Small Handicraft Business (Oxfam, 1988, 43 p.)

Acknowledgements

Introduction

I. Cost calculations in the handicraft industry

(introduction...)

I. 1. Production costs

I.2. Overhead apportionment

I.3. Selling and distribution costs

I.4. Ways to reduce costs

II. Pricing

(introduction...)

II. 1. Value in the market

II.2. Costs and pricing

II.3. Contribution analysis

III. The concept of working capital

III.1. Defining working capital

III.2. The role of working capital

III.3. Performance measurement

III.4. Profits

IV. Financial planning and decision making

IV. 1. Management Accounting

IV.2. Planning for working capital requirements

IV.3. Releasing cash from other assets

IV.4. Working capital decisions

Conclusion

A manual of credit & savings for the poor of developing countries

II.3. Contribution analysis

The problem can be expressed in this way. Suppose a buyer came along and offered to buy 1000 mats, but insisted on a 10% discount on the price of 44.00. A quick calculation could suggest that the business should turn down the order. Total production cost is 40.10, and a 10% discount would mean a selling price of 40.0(). It would seem that a loss would be made by executing the order.

Or would it? The answer depends on whether there is spare production capacity. If there is, the business should accept the order, because in fact it is going to make not a profit, but a contribution to overheads. Where production capacity is available, a business should accept any order from which the revenue exceeds the variable costs of production, because it is thereby gaining income which will go towards meeting its fixed overheads (Figure 6).

Figure 6. Contribution Analysis of Sale of 1000 Fibre Mats

	Money unit
Unit selling price of mat	40.00
Direct and variable indirect costs of one mat
(as per Figure 5)	35.10
Unit contribution	4.90
Total contribution to overheads on sale of 1 000 mats	4.900

Of course, it cannot operate in this way all the year round; its fixed overheads must be covered eventually. But in a lean period, keeping the distinction between variable and fixed costs in mind can assist in decision making about whether to offer discounts, reduce prices, or give a commission to a sales representative. contibutionwhich is revenue less variable costs—should be distinguished from profit—which is revenue less variable and fixed costs. A business breaks even where the contribution equals the fixed costs.

Contribution analysis can be represented diagramatically, to reveal the break even level of production of either a single product or the whole production unit. It shows the costs and revenues at different levels of production.

Break Even Production Level

It is admittedly of limited usefulness in the handicrafts industry, because fixed costs are usually small. But it serves to emphasise that flexibility is an important element in pricing. An over-rigid application of a cost plus pricing policy might lead to under-achievement of sales. through disregarding opportunities for occasional special offers or discounts which will maximize employment potential without detriment to financial performance. If a particular product is a hot seller and yields sufficient return to cover all the fixed costs. then the other products in the range could be priced on the basis of covering the variable costs of producing them. Or. if a price is reduced to just above variable production costs, and a large increase in sales results, the overall contribution to overheads might be greater, as well of course as the employment benefit.

A standard mark-up is not necessarily the most helpful approach to pricing. It is usually worthwhile to experiment with price changes to test the relationship between price and demand.

Accurate costing is not just a basis for pricing individual products, but it can also provide the information necessary for deciding on the most advantageous type of product range development.