Contribution and Break-even Analysis A2 Accounting

Content Break even analysis Break even analysis and decision making Contribution Special order decisions

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

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

methods 1.Break even = Fixed costs / contribution per unit 2.Graph 3.Table

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

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

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

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

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

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

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

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