The Contribution Margin Controversy
Contribution Margin Main

Summary by James R. Martin

The contribution margin approach, variable costing and direct costing all refer to the same thing.  An argument for or against one of these concepts is an argument for or against all three. Cost-volume-profit analysis (break-even analysis) is also based on the contribution margin approach. (See MAAW's Chapter 11). CVP analysis can be performed using absorption costing, throughput costing or ABC, but adjustments have to be made for the inventory change effects involved when using these methods. 

The contribution margin controversy involves three separate, but related issues. All three involve defining the purpose of the information generated, i.e.,  how the concept of meaningful is defined?

    1. The first issue is fairly old and has to do with the matching concept. Meaningful
        may be defined in terms of matching cost and benefits. The question is simply,
        does the method provide proper matching according to GAAP? An underlying
        question is, what is product cost?

    2. The second issue is about motivation and is also fairly old, but still unresolved. 
        It can be framed as a question of whether or not the method promotes a push
        system or a demand pull system. Does it provide management with the right
        signals to eliminate waste and produce only what is needed? Is it consistent with
        the concept of continuous improvement?

    3. The third issue is relatively new, or at least has been receiving renewed emphasis
        since activity based costing became popular. It can also be framed as a question.
        Which method provides the information needed for making strategic decisions
        such as product introduction, product pricing, outsourcing, and product mix?

The arguments below are all related to these three issues and questions.

I. Arguments against the Contribution Margin Approach.

    From the GAAP perspective

    It violates the matching concept. 

    From the Lean enterprise perspective

    It fails the signals or push or pull motivation question for the following reasons.
    1. It promotes short run optimization, not continuous improvement.
    2. It ignores quality, customer satisfaction and other lean enterprise values.

    It fails the strategic decision support question for the following reasons.
    1. It is based on a simple one product company that is not realistic.
    2. Fixed costs are assumed to be constant and this is not realistic.
    3. Production volume is assumed to be the only cost driver.
    4. Since profits increase beyond the break-even point, this method promotes
        producing as much as possible as long as you can sell it at a price above the
        contribution margin. (CM Model graphic illustrations.)
    5. It ignores the inevitable overhead creep that results from more product diversity and 
       assumes that average fixed cost per unit will decrease as more units are produced. 
      (See the Exhibit 8-6 graphs).
    6. It supports the view that the firm should never drop anything as long as it
        produces a positive contribution margin.

    1. The matching concept is irrelevant for internal reporting. (Question 1)
    2. The CM approach is neutral in terms of production, rather than providing a bias towards
         overproduction, i.e., there is no inventory change effect in direct costing,
        so it does not reward over production. (Question 2) 
    3. ABC is just a form of full absorption costing and this approach is the one that
         provides the major bias to overproduce. For example, if the number of setups is used to 
       assign costs to products, managers might reduce the number of setups and produce larger
       batches of products than needed, i.e., promoting a push rather than pull approach. (Question 2)
    4. It is useful for some short run decisions such as a special order. (Question 3)
    5. It is easier for management to understand than absorption costing or ABC 
        because there is no inventory change effect to confuse management. (Question 3)
    6. Production volume is not the only driver, but it is the major cost driver.
    7. It does not discourage continuous improvement as the critics say. It can be extended to a
        continuous improvement approach by focusing on the output of the constraint. Luther &O'Donovan 
        refer to this TOC concept as cost-constraint-profit analysis.
    8. It can be used as a dynamic approach where the variables in the model are
        changed as needed to reflect improvements.