Practise distinguishing full from contribution costing and analysing the assumptions and limitations that affect pricing, product continuation and special-order decisions.
Analyse two limitations to a business of using contribution costing.
Analyse two limitations to a business of using contribution costing.
There are 8 marks in total for Q5(a) - 4 marks for each of the two limitations to a business of using contribution costing:
1 mark for
1 mark for
2 marks for
Indicative content
Responses may include:
AO1 Knowledge and understanding
1 mark for identifying one limitation to a business of using contribution costing
- It allocates only direct costs to cost/profit centres
- Overhead costs not apportioned at all
- May provide a misleading picture of profitability
- It overlooks the impact of fixed costs
- Not acceptable for external financial reporting
- Difficult to allocate costs accurately across a full product range
- Not an appropriate method for price determination
- Unsuitable for capital intensive operations/multi-product operations
5(a)
AO2 Application
1 mark for application of one limitation to a business of using contribution costing
- Difficult to analyse as not all costs can be easily split into fixed and variable costs.
- Poor method for setting prices - as prices are based on contribution which does not cover fixed costs.
- It violates the principle of matching costs with revenues
- Has limited scope - so businesses with high automation have high levels of fixed costs, so not suitable to capital intensive industries.
- Can lead to unrealistic financial statements - as exclusion of fixed overheads in valuation of stock.
- Firms might find it difficult to cover all costs and earn a fair return on capital employed
AO3 Analysis
2 marks for developed analysis of one limitation to a business of using contribution costing L2
1 mark for limited analysis of using contribution costing L1
- Not acceptable for stock valuation - if stock is undervalued it could lead to government investigation/fines - affect business image
- Unrealistic financial statements - could lead to investors withdrawing from the business or government fines.
- Under-pricing of products - which leads to poor return on capital employed and low profits - shareholder dissatisfaction
- Costs can be difficult to allocate - which leads to inaccurate pricing decisions - lose customer loyalty
- Can lead managers to maintain the production of goods just because of positive contribution - perhaps a brand new product should be launched instead which makes a greater contribution.
- If lower prices are offered to gain customers as contribution can still be earned - may lead to existing customers demanding lower prices - lower profits.
- If high prices are a key feature that has established brand - then lowering prices could destroy brand image.
Accept all valid responses.