By Contribution, I am referring to Sales minus Variable Cost. In my four decades of working in Industry, I had applied this concept in many organizations, with great gains. For me today, it is perhaps the most important concept in Management Accounting. In one organization, it helped in achieving a turnaround. In another, it helped in evolving a profitable pricing strategy. In the third, it helped in cutting down losses by millions of rupees. I am sharing these 3 instances, in this article. But before that, let us recapitulate what we mean by term “Contribution”.
We said, Sales minus Variable Cost is Contribution. In a manufacturing company, Raw Material Cost is an important example of Variable Cost. Variable Cost varies with the level of activity. Thus when production goes up Raw Material Consumption goes up, and when production comes down, proportionately, Raw Material Consumption, and consequently cost would come down. In a trading environment, Purchase Cost is the most important Variable Cost.
If a trader is dealing in “pens”, buying them at a rate of Rs 6 per pen, and selling them at a rate of Rs 9 per pen, Rs 3 per pen is his Contribution. In terms of percentage of Sale Value, Contribution here is 33%. Let me extend this simple example to talk of two more related terms. If his only other cost is Rent, which is Rs 300 pm., and in a month he purchased and sold 100 pens, he made no profit or no loss, and this is his Break Even Level. At Break Even level, his Fixed Cost (Rent) is equal to his Contribution (Sales Rs 900 minus Purchase Cost Rs 600 for 100 pens). But for every pen he sells beyond his Break Even level, hiss Contribution is equal to his profit. It is this principle, which is put to effective use by companies in their product pricing decisions. Similarly, if organizations do not keep track of their true Variable Cost, and go on extending discounts on product prices, they could end up losing on every sale they make below their Variable Cost. Let us now see the 3 cases. These are real instances.
It was a Piston Manufacturing Unit producing Automotive and Locomotive Pistons. Manufacturing process involved producing “Castings” made of Aluminum Alloy in a Foundry and Machining them in a Machine Shop to have the finished product. In the Machine shop, each “Casting” goes through machining operations on about 25 machines in a sequence. If machining on the first machine is stuck, second machine would not have any load. In this process workmen were able to control the output. Management negotiated with the Workers’ Union, for a fixed output per shift from each machining line and permitted workmen to loiter, once their quota was achieved even if shift time was left. We needed to incentivize the workmen to produce more.
Specialty of this product was that it was a product with high contribution, which was about 65%. What it meant was that in a Sale Value of Rs 100, only Rs 35 was its Raw Material Cost. With low output levels, the plant was operating at its Break Even level producing 60,000 pistons per month. Every piston of Rs 100 produced and sold above this level gave the company Rs 65 in profit. Offering 10% of this profit gain to the workmen, through a Group Incentive Scheme, we came to an agreement with the Workers Union, after protracted negotiations. Then the plant started producing 1,10,000 pistons per month, which eventually went up to 1,50,000 pistons per month, and each workman was carrying home an extra wage as incentive. The plant made record profits and never looked back. It was a great turnaround!
Product Pricing Strategy
It was a Power Cable Manufacturing Company. Here Industry Practice was to commonly declare what they called List Prices, which were generally above the current market prices, and continue offering discounts on the list price, to match the best possible price the product could fetch under prevailing market conditions. Such list prices were revised only once in about 5 years. Power Cable Product range was Aluminum Cables or Copper Cables with different material compositions.
Due to a glut in the Capital goods industry, steep discounts had to be offered over a period 3 or 4 years, such that discount levels were going up to 60% in some products. The company followed one discount for Aluminum Cables and another for Copper Cables. Due to uneven inflation in individual raw material prices over the 3 year period, uniform discount meant varying percentages of Contribution, and in some cases where the discounts went high, some products were giving negative contribution. What it meant was that the company was not recovering its raw material cost in certain cases. When we collected data relating to such cases in a six month period, negative Contribution amounted to Rs 2 crores, which was the overall loss incurred by the company during that period. If it had avoided these orders, it could have avoided loss for that period.
The company moved from “Discount” based pricing to “Contribution” based pricing.
Optimum Level of Output
It was an Integrated Steel Plant. Energy is the most important Variable Cost for a Steel Plant. This plant was catering to both export and domestic markets. It was producing 100,000 tonnes per month for domestic market and 40,000 tonnes for export market.
The company’s Costing department was preparing Product Cost and Contribution Statement which was showing the overall picture, with average realization of Rs 12,500 per tonne, Variable Cost of Rs 9,200 per tonne, a Contribution of Rs 3,300 per tonne.
One important input relating to energy cost prompted me to address the issue differently. The company had two sources of Energy. One was Gail Gas which was adequate for producing 100,000 tonnes per month, and a Gas from a Private Sector Company, which was used for producing another 40,000 tonnes. Gas from Private Sector Company was 3 times costlier than Gail Gas.
If I assumed that we produced steel for domestic market with Gail Gas and for export market with the Gas from the private source, it gave a different picture on the Contribution front.
Against overall average realization of Rs 12,500 per tonne, domestic realization was Rs 13,100 per tonne and export Realization was Rs 11,000 per tonne. Similarly, against overall Variable (gas) Cost per tonne of Rs 9,200 per tonne, Domestic Gas Cost with Gail gas was Rs 8,500 giving a contribution of Rs 4,600 per tonne. Export Gas cost with private gas touched Rs 11,000 per tonne giving no contribution from Export operations at the prevailing prices. We considered only Gas cost here. There were other items of Variable cost as well in Export operations, making Export operations unviable. The organization immediately reduced production to 1,00,000 per month, catered only to domestic market, suspending Export operations and managed to cut down costs and consequently losses by about Rs 4 crores per month.
All the 3 instances above meant significant value add to the respective organizations, relevant under the price and cost conditions prevailing then. They are powerful stories. That is why, I have no hesitation in saying that Contribution is a Concept I love most.
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Thank you for your attention
Tulasi s Sastri