Summary of the Contribution Margin Controversy

Provided by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida

Contribution Margin Main Page | Activity-Based Costing Main Page

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.

From the ABC perspective

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.

II. Arguments for, or In Defense of the Contribution Margin Approach

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.

______________________________________________

Related summaries:

Demmy, S. and J. Talbott. 1998. Improve internal reporting with ABC and TOC. Management Accounting (November): 18-20, 22 and 24. (Summary).

Hepworth, S. R. 1954. Direct costing - The case against. The Accounting Review (January): 94-99. (Summary).

Johnson, H. T. 1989. Professors, customers, and value: Bringing a global perspective to management accounting education. Proceedings of the Third Annual Management Accounting Symposium. Sarasota: American Accounting Association: 7-20. (Summary).

Kee, R. C. 2001. Implementing cost-volume-profit analysis using an activity-based costing system. Advances in Management Accounting (10): 77-94. (Summary).

Martin, J. R. Not dated. Chapter 11: Conventional Linear Cost-Volume-Profit Analysis. Management Accounting: Concepts, Techniques & Controversial Issues. Management And Accounting Web. Chapter11

Martin, J. R. Not dated. Chapter 14: Investment Centers, Return on Investment, Residual Income and Transfer Pricing. Management Accounting: Concepts, Techniques & Controversial Issues. Management And Accounting Web. (Shows the relationship between Cost-Volume-Profit and Return on Investment). Chapter14

Martin, J. R. Not dated. Contribution Margin Models. Management And Accounting Web. ContributionMarginModels

Martin, J. R. 1994. A controversial issues approach to enhance management accounting education. Journal of Accounting Education (Winter): 59-75. (Summary).

Robinson, M. A., ed. 1990. Contribution margin analysis: No longer relevant/strategic cost management: The new paradigm. Journal of Management Accounting Research (2): 1-32. (Summary of Kaplan & Shank arguments).