Computational mechanics and biomedical engineering simulation

¶ … margin concept, so as to be able to properly evaluate whether or not a bulk order should be accepted. As such, the contribution margin concept is calculated as the sales revenue less variable costs.

The first important observation, connected to the issue whether or not a profit is made following an operation, is the fact that the contribution margin is not equivalent to an operational profit. Indeed, one needs to consider any fixed costs associated with the operation before calculating one's profit.

As such, in our case, the issue whether or not a bulk order should be accepted can be solved by calculating the contribution margin, subsequently subtracting any additional fixed costs that the operation involves and in the end decide whether or not the operation is profitable. In this sense, accepting or refusing an order is determined by the value of the contribution margin, notably on whether the value is positive or negative.

First of all, the company needs to evaluate the net sales that will be made by the accepted bulk order. Following, the variable costs need to be keenly estimated. In our case, variable costs may include costs of handling and packaging for the bulk order, costs of personnel handling the order, costs of transport, etc. At this point, we may have a reasonable estimate of the contribution margin and we will be able to subtract any of the fixed costs associated with the order. This may include cost of lighting in the warehouse or cost of rent for the warehouse where the order will be stored.

Finally, in my opinion, there is an important additional cost that should be included in the contribution margin evaluation. This is the opportunity cost. As previously mentioned, company resources will be used in order to be able to cover and handle the bulk order. However, we need to consider the fact that this resource could have been used for another company activity, an activity that may have produced more added value than receiving the bulk order.

In the end, the bulk order's acceptance or refusal is strictly determined by the value of the contribution margin. If this is positive and sufficiently large, the bulk order will be accepted. On the other hand, if the contribution margin (and here we need to include the fixed costs associated with the order and the opportunity cost I have mentioned) is negative, the bulk order will be refused.

b. The break-even volume can be defined as the "volume level at which a corporation reaches its break-even point, measured by the total fixed costs divided by the contribution margin per unit." The break-even point is of course the level where sales revenue equals total cost.

In this case, we have no information on the costs of production of lemon cookies or peanut butter cookies or on the sales revenue deriving from these activities. However, the important information refers to (1) the break even volume for lemon cookies, which we need to compare to the near-term demand and (2) to the status of peanut butter cookies, no longer profitable.

First of all, the break-even volume, the volume for which the company will reach break-even point on the lemon cookies in 650,000. This means that it will need to produce at least 650,000 lemon cookies in order to equalize production costs. In other words, the lemon cookies business starts being profitable at 650,000 units.

Second of all, the question we need to ask ourselves is whether the market would be able to absorb the break-even volume, the quantity that the company would need to produce in order to remain profitable. The answer is yes: there is near-term demand for 600,000 more lemon cookies that the company cannot cover yet. As such, we may conclude that both the near-term demand and the break-even volume figures are in favor of converting the peanut butter cookie production to lemon cookies.

Third of all, and perhaps this is the most important issue to consider, the peanut butter production is no longer profitable. It seems as an economical rationality to convert this activity into something that will produce more and that will be more efficient.

As such, considering the break-even volume for the lemon cookies, the absorption capacity of the market for the lemon cookies, as well as the current inefficiency and lack of profitability for the peanut butter cookies, a rational economic decision would point out towards converting the peanut butter production facility so as to produce lemon cookies.

c. The profitability of an activity can be easily estimated in relation with the contribution margin and break-even point of the respective activity. Indeed, first of all, the contribution margin, calculated as sales revenue less variable cost related to the specific activity, will tell us whether or not such an activity is bringing a profit for the company. Besides variable costs, one needs to take into consideration fixed costs associated with that activity, as well as any opportunity costs that may occur, due to the use of company resource for the activity at hand rather than for something other profitable activity.

The break-even point completes the contribution margin concept and helps discover the exact number of units that must be sold so that sales revenues will equal total costs. By performing a break-even analysis, the company will be able to determine whether or not it is able to produce the required number of units needed to make the activity profitable.

The operating leverage helps determine the extent to which fixed costs are included in the total costs of a company and influence the profit variations. Indeed, fixed costs do not vary according to the activity of the company. This means that, for a particular sale, if the proportion of fixed costs is sufficiently high and the variable costs low, the profits will not be determined by the variable costs and will thus remain at a higher level.

Fixed and variable costs are the main elements that form the company's short-term liabilities and have to be taken into consideration when estimating a company's profitability. Given the fact that, generally, one cannot influence the fixed and administrative costs, the important issue becomes how one can manipulate variable costs so that it will achieve the highest profit at a given level.

In my opinion, the three learning points that have been previously mentioned are important because they define means by which an activity within a company can be judged profitable or unprofitable and represent, from a financial point-of-view, the argumentation for a yes/no decision on whether to pursue a certain activity or not. In the end, concepts like contribution margins or break-even point resume to an explicit figure that will provide the basis for a decision.

d. I have used to Wal-Mart 2003 Financial Report, specifically the consolidated statements of income, where revenues and costs and expenses are mentioned, as compared to the value obtained for 2001 and 2002.