Contribution Analysis
Contribution - Sum of money that remains after all direct and variable costs have been taken away from the sales revenue. It is the amount available to contribute towards paying for fixed costs of production.
Contribution Per Unit = price - average variable costs
Total Contribution = (price - average variable costs) x quantity
Profit = total contribution - total fixed costs
Uses of a Contribution Analysis
Product Portfolio Management - By identifying the profitability of products in the business’ portfolio, managers will be able to decide which products should be given investment priority.
Pricing Strategy - Businesses can alter the pricing strategy of a product to ensure contributions are significant enough to cover fixed and indirect costs.
Make-or-Buy Decisions - Analysing potential contributions of a product can help a business decide whether it should produce the materials to build the product itself, or purchase them from suppliers.
Breakeven Analysis
Break-even analysis - A management tool used to diagram the level of sales of a product required to cover all costs of operation and production.
Breakeven Quantity = fixed costs / contribution per unit
Margin of Safety - The difference between a firm’s sales volume and the quantity required to break-even. The greater the positive MOS, the greater the profits for the business, whereas a negative MOS equates to a loss.
Margin of Safety = level of demand - break-even quantity
Limitations of a Breakeven Analysis
Assumptions of the Model
Assumes Cost Functions are Linear - The analysis assumes that costs rise proportionally with an increase in scale of operations. In reality, businesses will enjoy economies of scale as they grow their operations, meaning average variable costs will decrease. Likewise, fixed costs, such as wages and machinery required, will increase with an increase in production capacity.
Assumes Sales Revenue Function is Linear - The analysis assumes that the business will not adopt different pricing strategies according to rising and lowering levels of demand.
Assumes business will sell all output - The analysis assumes that sales will increase with output, and that all output will be sold. In reality, the business is bound to have unsold stock, meaning the costs of producing that stock needs to be covered by the revenue from sold output.
Limitations of the Model
Static Model - The analysis will not capture the dynamic business environment, and only diagrams the financial situation of the business at that moment in time. It ignores changing production costs, changing market demands, changes in competition, etc.
Single-Product - The analysis is only suitable for single-product firms that sell all of their output, and cannot be used by firms with a broad product portfolio.