Accounting: Using contribution and break even analysis

Fixed cost is independent of the level of activity (i.e. rent)

Variable cost varies with the level of activity (i.e. raw materials)

Semi-fixed (semi-variable) cost is a mixture of fixed and variable cost (i.e. electricity)

The break-even point (BEP) is the level of activity (in units of output or sales revenue) at which total cost (fixed + variable) = total sales revenue

BEP (in units of output)  =  Fixed cost for the period  / Contribution per unit

Knowledge of the BEP for a particular activity can be used to help assess risk

Contribution per unit = sales revenue per unit less variable cost per unit

Contribution margin ratio = contribution / sales revenue (x100)

Margin of safety = excess of planned volume of activity over BEP

Calculation of the volume of activity (t) required to achieve a target profit is as follows:

t = (Fixed cost + Target profit) / Contribution per unit

Operating gearing is the extent to which the total cost of some activity is fixed rather than variable

A profit-volume (PV) chart is an alternative approach to a break-even chart, which is easier to understand

Economists tend to take a different approach to break-even, taking account of economies (and diseconomies) of scale and of the fact that, generally, to be able to sell large volumes, price per unit tends to fall

There are non-linear relationships between cost, revenue and volume

There may be stepped fixed costs. Most elements of fixed cost are not fixed over all volumes of activity

Multi-product businesses have problems in allocating fixed cost to particular activities

In deciding whether to accept or reject special contracts, we consider only the effect on contributions

When resources are scarce, the limiting factor is most effectively used by maximising its contribution per unit