Business Finance - Contribution And Break Even Analysis

Revision notes on contribution and break even analysis for A2 business studies

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Emma Rudd
Finance and Accounts
Contribution and Break-Even Analysis ­ Text Book
Contribution can be calculated using the following formula:
Contribution = Sales ­ Variable costs
It has two potential uses; first it is available to pay fixed costs incurred by a business.
Secondly, any contribution, which remains after this transaction, is profit for the
Profit = Contribution ­ Fixed Costs
Contribution is also important in calculating break-even output and is a central element
of the formula used.
Calculating Contribution and Profits
It is possible to consider contribution in 2 ways ­ either in relation to a single unit of
output or in relation to the entire output of a particular project or business.
1. Contribution can be calculated for the sale of a single product. This is
contribution per unit and is calculated using the formula:
Contribution per Unit =
Selling Price (of 1 unit of output) ­ Variable costs (of producing that unit)
2. It is possible to calculate the contribution made by the sale of an entire product
(or product range) over some period say 1 year. Once fixed costs have been paid
the remaining contribution is profit.
Thus Profit = Contribution ­ Fixed Costs
Contribution can be used to calculate the level of profits for a business producing a
number of products. It can also provide managers with a clearer perspective of the
performance of a particular business ­ or part of a business.
Contribution Costing and Pricing
Contribution Costing
Contribution costing excludes fixed costs as a central part of the calculation. The
principle of contribution costing is valuable in a business that has a number of products
or several factories or divisions. A product or division that earns sufficient revenue to
cover its variable costs is likely to be viewed favourably by managers of the business. If
this is the case then the product will generate a positive contribution and assist in
paying fixed costs or providing profit.
The decisions whether to abandon a product of not will depend on a few factors;
Whether demand for the product may increase in the future, or if higher prices
can be charged.
If the firm can increase its output of other products to use any spare capacity it
may have, it may cease producing one product.
Whether fixed costs will fall as a consequence of the decision
The impact of the decision on the business e.g. the effects of industrial relations,
corporate image and productivity resulting from redundancies.
This approach to costing is based upon the firm's ability to categorise its costs fixed
and variable. In many cases this is straight forward, some expenses are most accurately
identified as semi-variable. Thus the cost of operating vehicles contain fixed elements
(insurance and vehicle excise duty do not vary according to the usage of the lorry) while

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fuel costs and drivers wages are clearly variable. The existence of such semi-variable
costs makes it difficult to calculate contribution accurately.
Contribution Pricing
The concept of contribution is also useful when taking pricing decisions. If the manager
or owner of a business sets a price higher than the variable cost of producing the
product then each sale will make a positive contribution to fixed costs. If sufficient
sales are made then the firm will earn a profit.…read more

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Emma Rudd
at short notice it is likely that the supplier will face higher costs. This may make the
order unprofitable.
Once again contribution is key to the decision. If the selling price exceeds the variable
costs and no additional fixed costs are incurred, the order would be worthwhile and
would result in increased profits. If such an offer arose a firm would need to;
Calculate the extra variable costs associated with the order - Overtime for
workers, more expensive materials etc.…read more

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Deciding whether to accept an order for products at prices different from those
normally charged.
In spite of its relatively simplicity break even provides managers with an effective and
clear method of analysis and can assist in making decisions such as setting prices or
accepting one off orders.
Break-even analysis can show the consequences to a business in terms of changing
profits (or losses) that may result from changes in fixed or variable costs or alterations
in the firms selling price.…read more

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fewer sales will be
necessary to B/E
Fall in selling price Revenue line pivots B/E is reached at a Every sale will earn
downwards higher output the business less
revenue so, as costs
are unchanged more
sales are required
to B/E
5…read more


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