CONTRIBTION MARGIN AND BREAKEVEN ANALYSIS a) Breakeven analysis implies the estimation of the revenue level necessary to run a business on a breakeven basis. Every manager should make sure that the sale price for a product or service will cover the variable costs incurred during the production of that product or service, and that there is a sales margin that covers fixed costs as well. Obviously, at this point, the company doesn't make any money, so some profit margin is also necessary. Performing a breakeven analysis reveals the real factors behind the profit potential of an organization, as varying the assumptions regarding sales levels and costs gives a more clear picture of the issues in question. Factors and assumptions in a buyer's business plan (such as the ability to set prices) are emphasized as a result of this type of analysis.
Before Maria should accept a large bulk order, she should check whether freeing up production capacity in order for her to be able to make the new products incurs loss for one of the goods she was previously producing, or not. If, for instance, she produces two types of cookies, she should make sure before diminishing the production capacity for either type that the contribution margin does not reach a critical point, equaling the fixed costs, or go even lower than that.
The concept of Contribution Margin refers to the fact that there is a certain value of the production volume for which the costs are covered but there is no profit to be made. The idea behind breakeven analysis and contribution margin is actually quite simple. The critical volume for which profit equals 0 may be calculated using the following formulas:
For starters, the Variable Cost per Unit may be calculated as Total Variable Cost per Current Volume.
The consequence is that total revenue which is Quantity (Volume) x Price per Unit (P) shall be equal to the Variable Cost per Unit x Quantity + Fixed Costs + Profit
P=VCU x Q + FC + Profit
Therefore Q. x (P - VCU) = FC + Profit and Q = (FC + Profit) / (P - VCU)
Since the Contribution Margin equals the Fixed Costs + Profit, the critical point mentioned above is reached when the Contribution Margin is equal to the Fixed Costs and Profit is null.
In Maria's case, the situation in December looks as follows:
FC = 600; Pr = 0; P = 2.25;
VCU = Variable Costs / Current Volume = $1,200 / 1,600 units = $0.75 / unit
The breakeven quantity (or Volume) in December may be calculated as (600 + 0) / (2.25-0.75); Q = 600 / 1.5; Q = 400
This is a more analytical description of the concept of Contribution Margin and Breakeven Analysis, which goes to the bottom of things. Actually, the Contribution Margin is a fairly artificial concept, since it is based on the adding up of the Fixed Costs and the total Profit. These two elements may seem fixed, but even Fixed Costs, (which include certain general and administrative costs, facilities costs, and interest and depreciation expense) may vary on a long-term. Profit also varies heavily, depending on market conditions, company financial management and policies etc. Therefore, in my opinion, a more analytical approach toward Breakeven Analysis is recommended, in order to obtain a clearer picture of the financial situation of a company.
As a conclusion, Maria should accept the bulk order only if the Profit exceeds 0 (or the Contribution Margin is larger or at least equals the Fixed Cost) for the product suffering the diminishing of the production capacity. Rather than losing money, the production of a particular good should be stopped altogether. If accepting the new bulk order involves losses regarding the production of a certain cookie and the breakout analysis suggest either increase of the production or a total halt, than Maria should reject the bulk order.
Actually, she could set off the losses incurred by the production of a certain product with the profits made as a result of accepting the bulk offer, if she thinks that a halt would damage her market-share or restarting the activity would prove difficult. This is one of the limitations of breakeven analysis. It does not necessarily follow that negative results of a breakeven analysis should cause the company to take immediate measures. Sometimes there are other reasons for which a business might continue to make a product or render a service and disregard adjacent losses.
A b) Well, if Maria's current production capacity could have been used to make some other type of cookies,...
Margin and Breakeven Analysis In order to address each separate concept and the practical situation in each case, we need to have clear definitions on the contribution margin and the breakeven analysis. In this sense, we may define the contribution margin as a "concept calculated as total revenue from a product or service less the total variable cost" It is one of the most important tools used in the case of
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