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Break-Even Analysis and Contribution
As we have seen the figure for cost of goods sold is taken off the sales revenue to give the level of gross profit. The cost of goods sold is made up of the direct costs of production - that is the costs that can be directly attributed to the production of that particular good. These direct costs will be very similar to variable costs - costs that vary with
the level of production.
They will tend to be things like raw materials, labour, packaging and so on. The level of these costs can be very important to a business. They have to be sure that they can cover both these costs and their indirect (fixed costs) if they are to make a profit. A useful technique for doing this is break-even analysis. To find the break-even point the firm needs to know
the contribution that each product makes to their fixed costs. Let's look at an example.
- Direct costs = £5 per unit
- Indirect costs = £1000 in total
- Selling price = £7 per unit
With these figures we can see that each time the firm sells one of its products it is making a contribution to its indirect costs of £2. So once it has sold 500 of the product it will have paid all its indirect costs. After 500 units the contribution goes to profit. Therefore if they sell 501 units they make £2 profit, 502 and they make £4 profit and so on. We can
show this on a graph.
Beyond 500 units we can see the gap between total revenue and total cost opening up rapidly. In other words the level of profit is growing fast. Once the fixed costs have been paid off, units sold are contributing directly to profit.
For some businesses this is very important as they have very high fixed costs. The next time you go to the cinema, think about the nature of their costs. How much do their costs change between having you on your own sitting watching the film, and a full cinema. You may prefer having a private viewing, but how much profit will they make? They've still got to pay for the rental of the
film, the ushers, the popcorn sellers, the managers and so on just for you!!! However, if the film is full they will still probably have the same number of employees there, but they will be making a totally different level of profit.
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