Business 5.5 Flashcards
What is contribution
Contribution refers to the sum of money that remains after all direct or variable costs have been taken away from the sales revenue of a product.
What is contribution per unit
Contribution per unit (or unit contribution) is the difference between the selling price of a product and its variable costs of production. The surplus goes towards paying fixed costs.
Contribution per unit = P - AVC
What is total contribution
Total contribution is the gross profit earned on the sales of the product.
Total contribution = (P - AVC) * Q or TR - TVC
What is profit in terms of contributiion
Profit is the positive difference between a firm’s total revenue and its total costs.
Profit = total contribution - total fixed costs
`= [(P - AVC) * Q] - TFC`
What is break even analysis
is a decision-making quantitative tool that allows business owners to forecast a level of production in any given price in order to cover all costs.
Carrying out a break-even analysis can inform managers of two important things:
Carrying out a break-even analysis can inform managers of two important things:
- Whether it is financially worthwhile to produce or launch a particular good or service
- The expected level of profits that the business will earn if things go according to plan.
But may also use it:
- To support an application for a loan from a bank or other financial institution
- To assess the impact of changes in the level of production on the profitability of the business
- To assess the effects of different prices and levels of costs on the potential profitability of the business
- To model changes to fixed and variable costs
what is break even quantity
Break-even quantity, also known at break-even output, is the level of sales required for a business to reach break-even.
what is break even point
- Break-even point is the point on a break-even chart where firm’s total costs equal to its total revenue, shown by the intersection of the TR and TC curves.BEP or BE = FC ÷ Contribution Per Unit
Total contribution and profit (talk about loss break even and profit in relation with Tr and TC
Profit/loss = Total Contribution - FC
Financial situations a business can be in:
- Loss: when TC > TR
- Break-even: when TC = TR
P * Q = TFC + TVC - Profit: TR > TC
WHat is the break even chart
Break-even chart is a diagrammatic representation of how total costs and total revenues change with increasing levels of production or sales. It shows a firm’s costs, revenues and profits (or loss) at various levels of output.
- The output at which this occurs is called the BEQ.
What is the margin of safety
Margin of safety, also known as the safety margin, this refers to the numerical difference between a firm’s volume of sales and its break-even quantity.
MOS = Current level of sales - BEQ
MOS (as %) = [(Current level of sales - BEQ) ÷ Current level of sales] * 100
What does margin of safety imply
- It indicates the degree of risk.
- High/Big MoS → Sales fall significantly and may still break-even
- Low/Big MoS → Sales fall relatively little and will make a loss (riskier than High Mos)
What is target profit output
Target profit output, also known as the target profit quantity, refers to the quantity of sales required to reach the firm’s target profit.
TPO = (FC + target profit) ÷ contribution per unit
WHat is target profit
the amount of profit that a firm aims to earn within a given time period.
What is target price
Target price is the price set by a firm in order to reach break- even or a certain target profit.
Increase in price effect on BEC
Effect on chart: Total revenue pivots upwards
Effect on contribution per unit: Increases
Impact of profit margin: Increases
Effect on break-even quantity: Falls
Effect on margin of safety if sales stay the same: Increases
Effect on profit: Depends on effect on sales, e.g., how much they fall. If they do not fall much, profit may rise.
Decrease in price effect on BEC
Effect on chart: Total revenue pivots downwards
Effect on contribution per unit: Decreases
Impact of profit margin: Decreases
Effect on break-even quantity: Rises
Effect on margin of safety if sales stay the same: Decreases
Effect on profit: Depends on effect on sales, e.g., how much they rise; if they rise enough profit may rise.
Increase in fixed costs effect on BEC
Effect on chart: Total costs shifts upwards
Effect on contribution per unit: No change
Impact of profit margin: Gross margin not affected but operating profit will fall
Effect on break-even quantity: Rises
Effect on margin of safety if sales stay the same: Decreases
Effect on profit: Reduces if sales do not change.
Decrease in fixed costs effect on BEC
Effect on chart: Total costs shifts downwards
Effect on contribution per unit: No change
Impact of profit margin: Gross margin not affected but operating profit will rise
Effect on break-even quantity: Falls
Effect on margin of safety if sales stay the same: Increases
Effect on profit: Increases if sales do not change.
Increase in variable cost per unit effect on BEC
Effect on chart: Total costs pivots upwards
Effect on contribution per unit: Decreases
Impact of profit margin: Decreases
Effect on break-even quantity: Rises
Effect on margin of safety if sales stay the same: Decreases
Effect on profit: Reduces if sales do not change.
Decrease in variable cost per unit effect on BEC
Effect on chart: Total costs pivots downwards
Effect on contribution per unit: Increases
Impact of profit margin: Increases
Effect on break-even quantity: Falls
Effect on margin of safety if sales stay the same: Increases
Effect on profit: Increases if sales do not change.
Advantage of break-even analysis as a decision-making tool
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Advantages
Simple technique: Expensive training is not needed and is suitable for new/small businesses.
Immediate results: It is a technique that can be completed quickly.
Financing: Be of value in supporting a business’s bank loan application so external stakeholders can determine the level of risk involved.
Strategy changes: A business can examine several different cost and revenue scenarios in order to consider strategy changes that might increase revenues or decrease costs.
Allows forecast: The effect of varying numbers of customers on its costs, revenues and profits.
Analyse profitability: For a business to assess whether its idea will earn a profit.
Limitation of break-even analysis as a decision-making tool
Assumptions made: The tool assumes all products are sold.
Simplification of the real world: It is difficult to use when businesses sell different products at different prices so the average would not be accurate.
Costs and revenues are not linear. Break-even analysis assumes costs and revenues are linear, but in reality, they are not.
Time-consuming for large product portfolios: Separate break-even analyses must be done for each product.
Changing assumptions: Costs and revenues will change, so businesses need to regularly update assumptions for break-even analysis.
Forecasts could be wrong if costs or selling price are incorrect.
