Contribution Margin and Breakeven Analysis

¶ … 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 pricing strategies and decisions, etc.

In Maria's case, accepting a large bulk order is equivalent to allocating some resources from the current resource pool in order to deal with the new order. If we have the hypothesis that the resources are constant over the given time interval, in the sense that she cannot hire new people to deal with the bulk order or new equipment, some of these have to be taken from the cookie production and moved to the bulk order. As such, the cookie production will be reduced.

In order to be able to properly evaluate whether this is profitable or not, Mary will be using the concept of contribution margin. In this sense, first of all she needs to calculate the contribution margin for the bulk order. The volume of the order is large, so we may expect the overall revenue, calculated by multiplying the volume by the per unit price, to be high as well. From this, we need to subtract the variable cost needed for the processing of the large bulk order, which is exactly the cost of the resources moved from the cookie production.

Considering these, the contribution margin for the large bulk order needs to be higher than the contribution margin of the cookies which will not be produced because the resources were allocated for the order. In this sense, if the contribution margin for the order is not higher, then it is not profitable for Mary to be accepting it, the cookie production bringing a higher contribution margin.

Breakeven analysis "is used to determine how much sales volume your business needs to start making a profit"