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 unit2. 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 • 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