- Created by: Sophie Chanoch
- Created on: 30-01-13 13:08
When the variable costs which a business accrues is deducted from the sales revenue which a business generates the contribution is attained.
Sales Revenue - Variable Cost = Contribution.
The contribution is the difference between the income which is generated from the sales revenue and the variable costs that were used to produce the revenue, making goods and services.
Once the variable costs have been deducted, the outstanding cost left is the fixed overhead costs. It can be concluded that the fixed costs overheads are paid for by the contribution because the contribution is what remains after a deduction of only variable costs have been made.
The contribution per unit is the amount that every single unit of produced goods will generate after the variable costs have been deduced and the fixed costs can be taken care of. Profit can only be generated after the costs have been taken care of. Buy teddy from supplier 4.20, sells for 6.40. Contribution = 2.20
Affect Contribution Per Unit
Selling price- the higher the selling price of the good or service, the greater will be the contribution per unit and vice versa. When this is high, the overhead costs can be taken care of more effectively including the rent or mortgage repayment for the business and utility bills.
Variable costs- a reduction in the outgoing of the business will ineversely affect the contribution per unit. As the business finds cost effective ways to produce its goods and services, the higher will be the contribution per unit available to the business.
Cost effective ways in which the business can reduce variable costs include outsourcing to cost effective and specialist contractors, switching to more affordable suppliers who provide similar or better quality of the same resources for production, minimising unnecessary expenses which the business accumulate without productive research.
Pricing, Profit and Contribution.
There's a link between the pricing, profit and contribution. Profit can only be generated after the contribution has covered the fixed overheads costs.
In order to set a reasonable price for the product, the business must consider the cost involved. When the cost is high, the set price is high otherwise it'll result in the high costs outweighing the profit potential of the goods and services.
As long as the selling price can outweigh the cost of production while the costs are kept to the very minimum, the contribution will be high.
With increased contribution per unit, fixed cost and variable costs are minimised and the profit which the business generate increases in proportion to the sales revenue which should exceed the total costs.
Businesses use contribution to determine whether the goods they produce are contributing in any way to offset the variable costs it incurs. The effect of this for the business is that it enables the business to set it prices based on what it actually spends on production of the same goods, instead of overstating the price to include the fixed costs of the business. Therefore products with a high contribution per unit will help to offset the fixed costs.
Contribution is also closely linked to break even. As a business increases its production it's expected that every individual product has a positive contribution to the business. In effect this means the products are covering the fixed costs quicker.
Since the business is increasing production range, it's anticipated that the revenue of sales will be high. As of the sales revenue rises and the contribution per unit rises, the fixed overheads costs will be paid off faster.
For new business start ups, the fixed overheads costs tend to be relatively high. As the sales revenue rises with contribution per unit, it'll in effect pay off the fixed costs faster and result in the making of business profits.
The point at which the contribution per unit equals and begins to exceed the fixed costs overhead is known as the break even point.
Break even point = Fixed Cost/ Contribution per unit.
Break Even Charts
In order to expand the concept of break even and its calculation, it's important to examine the break even chart. This chat shows a diagrammatic representation of the analysis and more in depth information on the costs and revenue at all levels of output and demand. A diagrammatic representation would require the following: Revenues, Output, Costs.
Break even point is the point at which the total revenue line crosses the total cost line.
Quantity of Produced Units= 0/500/1000. Fixed Costs= 3000/3000/3000. Variable Costs at 3 pound per unit= 0/1500/3000. Total Cost = FC + VC = 3000/4500/6000.
If goods were sold at a unit price 4.50. Output= 0/500/1000. Total Revenue = Output x unit price= 0/2250/4500.
When the break even chart is plotted based on the above information, then the break even point can be obtained.
There's an area of profit and loss in the BEP chart which shows the profit or loss that can be made. Any level of production of output that is above the break even point leads to profits. On the contrary, any area that falls below the BEP leads to potential losses.
Margin of Safety
Margin of Safety is the total revenue and total current output. Hence this reflects the current output level at any point on the total revenue line. This difference between the point on the total revenue line and the break even point is the margin of safety.
The implication of the margin of safety for the business is that it reflects the level of fall in demand for a product that can be experienced before it leads to business losses. Hence when this is understood by the business, it realises the need for a wide safety margin which occurs through creating greater gaps between the current sales and break even point.
Analysing Changing Variables and their Effects
Budget Plan- the effects of changes in the variable that affect the business profit and loss are shown in its budget plan. This plan proposed financial targets including the level of sales and production for a defined time period. It has the benefit of ensuring continues business focus to facilitate efficient planning and control.
Direct Costs- the changes in this type of variable tend to affect the variable cost of the business, and in effect, the total cost. It has several effects when the total revenue crosses the total cost line including : Altering the break even line, change in the margin of safety, change in the profit and loss areas, shift of the fixed cost line due to changes in the overhead costs which is a fixed cost.
Numerical Calculation- There's also numerical calculations which are involved in executing the budget action plan and helping the business attain its targets. It could be calculating the elasticity of prices which measures the impact of price changes on the demand for the product. Here's how to determine the price elasticity.
Price elasticity= The Percentage change in quantity demanded/ The Percentage change in price.
Changing overheads and Target profit levels of act
Changing Overheads- the changes in this type of variable tend to affect the fixed cost and total cost lines of the business. In effect, total revenue crosses the total cost line at a different point. It causes changes in the margin of safety, **** of the fixed cost line due to changes in the overhead costs which is a fixed cost, alterations to the breakeven line, changes in the profit and loss areas.
Target profit levels of activity- when there are changes in the profit area of the business, it'll need to seek to maintain the optimum revenue in order to sustain the best position for optimum profit.
Businesses must experience a fall in variable costs that are related with each level of output and causing the line of total cost to be reduced. Experience an increase in the price of each product sold, thereby reducing the units sold prior to the total cost line actually intersecting with total revenue to create the break even point. Experiences a fall in fixed costs to reduce the total cost.
Pros and Cons of Break Even Analysis
There are several merits and shortcomings of the break even analysis. These are reflected in the following poignant business areas. Consistency of the sale price, external factors, sales and production levels, the behaviour of overheads and contribution.
Consistency of the sale price- throughout the life cycle of any given product, it's bound to experience fluctuations in the price, depending on the market, consumers, raw material costs and many other factors. Hence it's no practical to assume that only one price is maintained throughout the product life. Unfortunately break even analysis assumers that the price doesn't change.
External factors- these factors include macroeconomic indicators such as fluctuations in interest rate, inflation and several other factors. These tend to affect the costs of production incurred by the business and as they vary, so do the business costs. These external factors aren't taken into consideration in the break even analysis.
Sales, Production Levels, Overheads and Contributi
Sales and Production Levels- Break even analysis assumes that the level of production and sales are matched by each other. In reality, this isn't always the case. Sometimes, there can be sales which exceed production and conversely, production can exceed actual sales. This is not taken into consideration in the break even analysis.
The behaviour of overheads and contribution- Contribution is very important in calculating the break even point. It should be noted that there are fluctuation in contribution which could change through increases or decreases in production, which will lead to profit increases or decreases in a very short space of time.
The behaviour of overheads or fixed costs can lead to enormous strain on the products as the contribution is greatly affected. These fixed costs can increase or decrease not with standing the output produced. This could be through changes in the rent prices or moving to a bigger complex o facilitate production. Such measures affect contribution per unit and inevitably will affect the break even analysis calculation.