If you’re looking at the profitability of an organisation, you’ll need to understand the difference between overall profit, and the contributions made by specific products. In this blog post we explain the difference between contribution and profit in accounting.
All organisations that are run with the objective of making a profit will complete a profit and loss report at the end of each financial period. This will show the revenue they have received, the amount that has been paid out in expenses, and the remaining amount of profit that has been made.
The profit and loss report takes into consideration all types of sales for all products and services. It also takes into account all the expenses of running the business, including both variable and fixed costs.
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Variable costs are those that vary with the amount of output by the business. This includes the wages of staff involved in production, as well as the materials used to make products.
Fixed costs are those that remain the same regardless of the amount of product that is made. This includes things like rent, rates, salaries, fuel, and depreciation.
Let’s look at an example:
Sales for the year are a total of £50,000.
The cost of sales is £15,000.
This means a gross profit of £35,000 has been made.
There are then running costs of the business:
Premises costs are £20,000.
Motor expenses are £5,000.
Other expenses are £3,000.
This leaves a net profit of £7,000.
The cost of sales represents the costs that are directly attributed to a sale, such as the material used in the production of the product. The running costs, on the other hand, are business overheads that are not directly attributed to the sale.
As well as overall profit, organisations are often interested in the of contribution of specific products towards paying fixed costs and making a profit.
It’s possible to calculate contribution per unit, or for the total number of units that are expected to sell. To calculate contribution per unit, you use the sales price per unit, minus variable cost per unit.
Here’s an example:
Company A makes a product that they sell for £25 per unit.
The direct cost of sale related to each unit is materials of £7 and labour of £10.
£25, minus £7, minus £10 leaves a contribution of £8 per unit. This goes towards paying off the fixed costs. Once the fixed costs are paid off, any further contribution goes towards profit.
Once the contribution has been calculated, you can use this amount to calculate the break-even point, which will tell you how many units you need to produce in order to make a profit or loss. To calculate the break-even point, you take the contribution per unit and divide it by the total fixed costs. This will show how many units you need to sell to cover the fixed costs, thus making neither a profit or a loss.
The difference, therefore, between contribution and profit is that contribution shows the difference between the sales price and variable costs for specific products. This then contributes to the fixed costs, and goes towards the profit of the business.
Profit, on the other hand, is the difference between sales and costs for the whole of the business. The profit can either be reinvested into the business, or taken out as dividends.