Contribution and Break-even Analysis

1. Contribution and Break-even Analysis A2 Accounting

2. Content • Break even analysis • Break even analysis and decision making • Contribution • Special order decisions

3. Break even • Break even is the point of production where are firms revenue is equal to the total costs of production • Margin of safety – the difference between the firms current level of output and break even output

4. Uses of break even analysis • Allows to decide if a business venture is financially viable • Looks at what will happen if level of production changes • To support an application for an external source of finance e.g. loan or mortgage application

5. methods • Break even = Fixed costs / contribution per unit • Graph • Table

6. Using break even analysis • Break even analysis can help managers to plan and in their operations • In addition it can help: • Analyse the impact of a change in the environment on the business • Decide whether or not to accept an order for products at a different price from normal

7. Changes in the business environment and Break even • If VC rise in value then break even output increases • If VC fall in value break even output decreases • If FC rise break even output increases • If FC fall break even output falls • If selling price increases break even output decreases • If selling price decreases break even output increases

8. Contribution • Contribution • Contribution is the total revenue – variable costs • It measures how much is being contributed the fixed costs by the units that have been sold • Contribution – Fixed costs = Profit • Can calculate contribution per unit or contribution for all units of output

9. Contribution costing and pricing • Contribution costing: • Only looks at variable costs • Useful for large, multi site businesses as can see which functions cover their variable costs • If a product failed to contribute fully to variable costs may not withdraw it depending on: • Whether demand may increase in the future • If firms' can increase output of other products or not • If FC will decrease due to withdrawing the product • How the decision will affect the business as a whole

10. Contribution Pricing • Pricing decisions can use principals of contribution • If price exceeds variable cost then the business knows the product is making a positive contribution • Its success is dependent on the firm selling their output at the price chosen

11. Special Order Decisions • This is when businesses need to decide if to accept orders that are on special terms • Prices lower than normal – if the contribution is positive generally accept the order • However have to consider: • If more FC result from the order • May the order increase the level of VCs • If the company will resell the product • If it may lead to future sales – if this is the case may accept an order that doesn’t make a positive contribution

12. Special Order Decisions 2 • Prices higher than normal • Normally would accept this • However if specifications have to be altered it may prove to be expensive for the business • The firm would need to: • Calculate any extra variable costs associated with the order • Assess if sufficient capacity to meet order • Decide if it increases contribution and profits

13. Summary • Break even analysis looks at the output required for the firm to cover all costs • Three methods of break even analysis – equation, chart, graph • Break even allows you to look at the impact of a change in the business environment • Contribution – total revenue – variable costs • Firms can use contribution costing and pricing methods to attempt to increase profitability • Special order decisions – look at how firms decide whether to accept orders that are out of the ordinary, need to consider contribution and additional factors