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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, than perhaps the new plant would have been appropriate for the production of lemon creme cookies, minding the fact that the volume should have exceeded 650,000 units, so that a minimum of profit is obtained. It actually depends on the total production capacity available to Maria and the demand on the market for certain types of cookies.
Obviously, it is not advisable for Maria to begin production of the lemon creme cookies if breakeven analysis indicates that she will lose as a result, since the extra demand is lower than breakeven production capacity for the new unit. The solution is a modification of the production product of choice at the old unit.
A c) The three points that I would like to mention are as follows:
1. The fact that, in my opinion, the whole concept of Contribution Margin is artificial
2. The fact that this concept is based on the idea that profits are fixed rather than variable.
3. The fact that the results of breakeven analysis are sometimes not considered, due to other factors on the market.
1. I stated that the concept of Contribution Margin is artificial. I believe that by adding the fixed costs and profit there is no new meaningful indicator to be obtained. Actually, a company may perform better by considering in a parallel fashion both the Fixed Costs, with everything they imply (including medium and long-term modifications, and the Profit margin, which may not be simply reduced to an annex of the Fixed Costs. An analytical approach is much more suitable, as I have already mentioned.
2. The concept of Contribution Margin is based on the idea that Fixed Costs and Profit have a similar nature, which is a simplification of the general picture. Although it is easier for a financial officer to work with simpler concepts, it is nonetheless damaging to the company, since all factors must be treated separately and according to their particular structure. Fixed Costs, for instance, are fixed only by name, as there are so many factors that could, on the long-term, modify their value. Simply consider a strike in the energy sector, or the recent increases in oil prices. The price of oil may have been considered fixed for a certain production capacity (e.g. The cost of heating a hall or the price of fuel for delivery vehicles, which may deliver a single product or a full cargo). These new developments may strongly affect a company's performance.
The Profit is also variable and depends on the general financial management policies. Say the shareholders request larger dividends at the end of a year. It is quite clear that the profit may not be reinvested, that he plans of the financial officer, if any, shall suffer serious modifications and that this has nothing to do with Fixed Costs. What if the fiscal policy of the state changes? Inherent changes shall appear in the structure and value of the profit. Therefore, the two components of the Contribution Margin should be treated separately, in order to perform a thorough analysis of the issues at hand.
3. Breakeven Analysis is not the alpha and omega of economical thought. There are companies which need to keep their product on the market, notwithstanding the losses incurred, simply because that particular product is the hallmark of the company, or because market-share will be lost or because future initiatives in that sector need to be spearheaded in some sort. Minor losses may be set off by revenues in other sectors, which may even be tax deductible expenses, but the gains from other points-of-view are difficult to measure. Imagine that the Big Mac at McDonald's would no longer bring profit. Would McDonald's renounce so quickly to produce it?
A d) The MergenT financial information service provides an article containing, among other things, Oracle Corporation's income statement. As it may be easily observed, the net income (loss) is treated separately and not together with Fixed Costs. There is no apparent relationship between profits and a fixed element. Although every company seeks to obtain a fixed net profit margin, it is not advisable that this margin be treated in a conservative way, without the possibility for subsequent modifications. The third point mentioned above is more difficult to prove. However, consider the possibility that servicing of an Oracle product is highly unprofitable or even brings losses. It is not conceivable that Oracle…[continue]
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