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Margin is quite simple and states that a certain value of the production volume exists for which costs are accounted for, but profit is null. This critical production volume is calculated by applying the following formulae:
The Variable Cost per Unit is calculated as Total Variable Cost per Current Volume. Therefore, aggregate revenue (Quantity (Volume) x Price per Unit (P)) shall be equal to the Variable Cost per Unit x Quantity + Fixed Costs + Profit
Q x P=VCU x Q + FC + Profit
x (P -- VCU) = FC + Profit and Q = (FC + Profit) / (P -- VCU)
The critical point is reached when the Contribution Margin is equal to the Fixed Costs and Profit is zero, since the Contribution Margin the sum of the Fixed Costs and Profit.
The first point I think that needs to be maid is that the Contribution Margin is an artificial construction introduced to simplify the lives of people working with it. Actually, this simplification can only lead to a decrease in efficiency. Why should the Fixed Costs and the Profit be added? This approach is purely synthetic and may lead to the omission of certain important aspects regarding the evolution of Fixed Costs on one hand and of Profit on the other. Should Fixed Costs increase and the profit decrease, the contribution margin will remain constant, which may create confusion and cause financial officers to take wrong decisions, as they are not correctly informed.
I would suggest instead the use of an analytical method and the separate approach of each of the two components. Fixed Costs may be evaluated more accurately, on the long and short-term, and profit would no longer be reduced to an appendix of the Fixed Costs. Although this way of handling things would request additional accounting operations, I think it is a more suitable method to tackle the problems posed by the two components.
After all, Fixed Costs are not so fixed. Prices may have important variations on the medium and long terms, and price bubbles may even appear on the short-term. The recent oil shortage problems have already caused increases in energy prices, which, despite being considered fixed, have created serious problems for financial managers. If we should stick to a stable Contribution Margin, the increase of the Fixed Costs would be set-off by the decrease of the profit and, therefore, of the profit margin. Company performance would be affected only because of the simplified approach imposed by the use of the Contribution Margin concept.
The profit margin is compatible with important changes on the short-term. Company objectives often cause CFO's to take drastic measure in order to satisfy shareholders' demands, short-term growth policies or other similar actions. Suppose a law imposing a progressive profit taxed is emitted. Fiscal consultants may advise for the profit to be diminished and for tax deductible expenses to be maid, in order to avoid payment of higher taxes. The profit margin would suffer important modifications. How is this alteration easily integrated in the concept of Contribution Margin?
The conclusion of this first point is that Profit and Fixed Costs do not have a similar nature. Considering Fixed Costs "fixed" is a simplistic approach. Considering profit "fixed" is a naive approach. Adding the two "fixed" components is an almost useless action. What economic environment is so stable that the evolution of the two elements may be considered accurately predictable and reliable? Although applying this method may not cause any damage to a small family business, a large corporation cannot afford to simply add two numbers (Fixed Costs and Profit), and act only on the information provided by the total. It just isn't doable, because these elements have different natures.
The second point that I would like to make is that the concept of breakeven analysis does not necessarily dictate whether production of a certain object is interrupted or not, should the profit fall below zero. There are numerous reasons for which a company would choose to continue production because losses are set off by gains in promotion or in other sectors.
Some companies base their marketing strategy on one particular product. The Coca-Cola Company would never stop the production of Coca-Cola, even if it would suffer losses, according to a breakeven analysis, simply because the product is the symbol of the entire organization. A company may wish to keep its market share for a while, as it is experiencing various reforms, and then compete at full capacity with rival firms, which have managed to produce at lower costs in the mean time.
Of course, one very interesting thing one might do is to investigate the legal consequences of selling something for a price under the production costs. Anti-dumping regulations may prohibit such an action, especially if it takes place for an extended period of time. Most states have very strict regulations in this area.
The third point I think is worth mentioning is that the whole idea of breakeven analysis is a scholastic simplification of the economic processes which are taking place in an organization. After all, it's no big secret that the price should be larger than the cost, and that the difference between the two is profit. However, the real life brings a few surprises.
For instance, every sensible person would state without hesitation that a company which is suffering losses is on its way to bankruptcy. This is not always true. Losses may be provoked on purpose, or may not even be real (since company books may be falsified in order to avoid paying taxes). Losses are deductible from the profits reported in previous years, so an unscrupulous manager may use this facility to purposely lead the company to start losing money, which will be than compensated with anterior profits.
Expenses may be artificially increased and may become larger than the actual income. The difference is obviously reported as a loss. A loss is not subject to taxes and may even be considered a solution for tax avoidance. The point I am trying to make is that breakeven analysis is not to be evaluated on its own, but also in conjunction with state fiscal policies and the attitudes towards taxation of companies' managers.
I have obtained the income statement of Xerox Corporation from the MergenT financial information service, which provides articles about all major companies in the U.S.A. It is easy to notice that the net income (or loss) is analyzed in a separate manner from Fixed Costs, and there is no obvious connection between fixed elements and profit.
The goal of each company is to obtain a fixed profit margin, so that shareholders, investors, creditors and other interested parties may rely on it. However, approaching the profit margin issue conservatively reduces the chances of a corporation to flexibly adjust to changes in the economic environment.
The second point, referring to production of articles for which the profit is negative, is not something to be found in an income statement and is more of an internal problem of the company. However, Xerox sells a lot of products for which servicing is necessary. Service Spare parts may prove unprofitable to make. Still, it is inconceivable to think that Xerox does not provide such services just because it costs a little more than it brings, as long as the good name of the company is at stake.
The third point is impossible to make in Xerox's case, as this is one of the corporations that have performed very well lately. It is unlikely that Xerox's managers resort to such practices in order to simply cheat the revenue service.
Xerox's future activity should be concentrated on maintaining the current levels of revenue and net income. Xerox's performance has been quite surprising in the last…[continue]
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