Referring back to our initial example, each unit of product that is sold brings in $100 with a contribution of $35 to gradually reduce the original lose (I will assume that the company is able to produce and sell 10,000 units of a particular product). Break-even point is that point where a firm neither makes a profit nor loses. The extra money earned will be used to reduce the fixed cost of the business.īREAKEVEN CALCULATION: A business that starts operation today does not make profit if it doesn’t make sales to help write off the initial cost of starting a business. Decision needs to be made as to whether to sell at that only available price or not, this is one of the instances when the right decision will be made using the contribution analysis that we have described above. Below are some specific situations where contribution analysis is handy.įIXING MINIMUM SELLING PRICE: It is a good idea for companies to target selling prices that will cover both fixed and variable costs, but there are times when factors beyond the control of the business may arise subsequently leading to a situation when stocks are being piled in the warehouse, all of a sudden, a willing buyer approaches the entity with an offer below the fixed selling price of the business. Generally, contribution analysis is a powerful decision making and budgeting processtool that management accountant functionsand managers use to aid most managerial decision making processes. Contribution analysis is based on marginal cost concept, not the subject of this article. The above example reveals that producing and selling another unit will allow the company to make a contribution of $35 without incurring additional fixed costs. Relevant costs are cost that can be avoided if not for taking up a task or project just like relevant cash flows. The concept of contribution analysis is centered on variable costs as they are the relevant costs as far as decision making is concerned. It is calculated thus: unit selling price of a particular product less variable cost of producing that product.
Hence, I would like to start with the definition of contribution analysis, and how it is calculated.Ĭontribution analysis is defined as: the payment made by individual products towards recovering the fixed cost of a business, this payment quickly become profits once the fixed cost of a business has been fully met. The use of contribution analysis cannot be fully understood if the meaning of the term is not first explained.
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