OPERATIONS MANAGEMENT output, Costs are greater than Income.

At the
point of intersection, P, costs are exactly
MODULE 2.2 – BREAK EVEN equal to income, and hence neither profit nor
loss is made.
ANALYSIS
LEARNING OUTCOMES FIXED COSTS
• Understand how break-even analysis is Fixed costs are those business costs that are
important in determining pricing. not directly related to the level of production or
• Familiarize ourselves with the measures of output. In other words, even if the business has a
profitability. zero output or high output, the level of fixed costs will
• Discover how these measures of profitability remain broadly the same. In the long-term fixed
are relevant to price determination. costs can alter - perhaps as a result of investment in
• Learn the difference between gross margin production capacity (e.g., adding a new factory unit)
and contribution margin. or through the growth in overheads required to
support a larger, more complex business.

BREAK EVEN ANALYSIS

Examples of Fixed Costs:

• Rent and rates

• Depreciation
• Research and Development
• Marketing costs (non-revenue related)
• Administration costs

VARIABLE COSTS

Variable costs are those costs which vary

directly with the level of output. They represent
payment output-related inputs such as raw
• Break-even analysis is a technique widely materials, direct labour, fuel and revenue-related
used by production management and costs such as commission.
management accountants.
A distinction is often made between "Direct"
• It is based on categorizing production costs variable costs and "Indirect" variable costs.
between those which are “variable” (costs
that change when the production output • Direct variable costs are those which can be
changes) and those that are “fixed” (costs not directly attributable to the production of a
directly related to the volume of production). particular product or service and allocated to
• Total variable and fixed costs are compared a particular cost centre. Raw materials and
with sales revenue in order to determine the the wages those working on the production
level of sales volume, sales value or line are good examples.
production at which the business makes • Indirect variable costs cannot be directly
neither a profit nor a loss (the “break-even attributable to production, but they do vary
point”). with output. These include depreciation
• In the diagram, the line OA represents that (where it is calculated related to output - e.g.,
variation of income at varying levels of machine hours), maintenance and certain
production activity (“output”). OB represents labour costs.
the total fixed costs in the business. As
output increases, the variable costs are
incurred, meaning that total costs (fixed +
variable) also increase. At low levels of
 CONTRIBUTION ON MARGIN PERCENTAGE

• The concept of a contribution margin comes

from the need for business managers to
understand how profitable their businesses
have become.
• For most managers, this is as simple as
looking at something called the profit margin.
• The profit margin is simply the amount by
which revenue, which the business gets from
the sales it makes, exceed the costs incurred
CONTRIBUTION MARGIN by the business, both variable and fixed.
• Contribution margin is a product’s price • Sometimes, that figure is expressed as a
minus all associated variable costs, resulting ratio, in which case it will be known as the
in the incremental profit earned for each unit contribution margin ratio, and sometimes it
sold. will be expressed as a percentage, in which
• The total contribution margin generated by case it will be known as the contribution
margin percentage.
an entity represents the total earnings
available to pay for fixed expenses and to
generate a profit.
• The contribution margin concept is useful for 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛
𝐶. 𝑀 (%) = × 100
deciding whether to allow a lower price in 𝑆𝑎𝑙𝑒𝑠 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
special pricing situations.
• If the contribution margin at a particular price
point is excessively low or negative, it would Example 1:
be unwise to continue selling a product at
For example, let’s look at how this might work in
that price.
practice with a sporting goods company.
• It is also useful for determining the profits that
will arise from various sales levels (see the Imagine that a basketball costs £20, with variable
example). costs per unit of £8. So, to find the contribution
• Further, the concept can be used to decide margin ratio, we can use the following formula:
which of several products to sell if they use a
𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑉𝐶
common bottleneck resource, so that the 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑀𝑎𝑟𝑔𝑖𝑛 𝑅𝑎𝑡𝑖𝑜 =
product with the highest contribution margin 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
is given preference.

𝐶𝑀 = 𝑃 − 𝑉𝐶
What does that mean?
Where:
Essentially, it indicates that for this company,
• CM = Contribution Margin the contribution margin for every £1 of revenue is 60
• P = Price cents.
• VC = Variable Cost

Therefore, the Contribution Margin is:

The amount of a product’s price that remains after

subtracting the product’s variable costs.
Example 2: ( 170.50 − 35.40)
%𝑪𝑴 = [ ] × 100
Now, let’s look at another example. Imagine the 170 .50
same company sold around $50,000 worth of ( 135.10)
basketballs within a given period, with variable costs =[ ] × 100
170.50
of $20,000. However, the company also has fixed
costs of $40,000. We can use the contribution = ( . 79237537) × 100
margin formula to find out what this means for their
bottom line: = 𝟕𝟗. 𝟐𝟒%

50,000 − 20,000 = 30,000

While the contribution margin is $30,000, the PROBLEM NO. 2
business’s fixed costs (premises, staffing, Given:
insurance, etc.) mean that the company is making a
net loss of $10,000. As a result, they need to • Price = Php 60.15
decrease their fixed expenses or boost prices if they • Variable Cost = Php 8.75
want to remain solvent and stay afloat.

𝑪𝑴 = 𝑃 − 𝑉𝐶
= Php 60.15 – 8.75

= Php 51.40

( 𝑃 − 𝑉𝐶 )
%𝑪𝑴 = [ ] × 100
𝑃

( 60.15 − 8.75)
%𝑪𝑴 = [ ] × 100
60.15

( 51.40)
=[ ] × 100
60.15

= ( . 85453034) × 100
SAMPLE PROBLEMS
= 𝟖𝟓. 𝟒𝟓%
PROBLEM NO. 1

Given:

• Price = Php 170.50

• Variable Cost = Php 35.40

𝑪𝑴 = 𝑃 − 𝑉𝐶

= Php 170.50 – 35.40

= Php 135.10

(𝑃 − 𝑉𝐶 )
%𝑪𝑴 = [ ] × 100
𝑃
TWO MEASURES OF PROFITABILITY the variable costs from the unit selling
price.
Gross Margin - Defined by the standard accounting • The contribution margin is typically
concept “cost of goods sold,” which is not the same expressed as a percentage by dividing the
as a product’s variable costs. contribution margin by the unit selling price
and multiplying by 100. It helps a company
Contribution Margin - Defined by a product’s
understand the profitability of each product
variable costs. or service and is particularly useful for
making decisions related to pricing,
product mix, and resource allocation
CONTRIBUTION ON MARGIN vs GROSS
MARGIN
• In summary, gross margin provides a
broader view of overall profitability,
considering all costs of goods sold, while
contribution margin focuses on the
profitability of individual products or services
by considering only the variable costs directly
associated with them.

LINKS
• So, when it comes to contribution margin vs. • Contribution Margin
gross margin, what’s the difference? https://youtu.be/CN7dJSmnWAM
• Well, while contribution margin provides you
with a per-item profitability metric, gross
margin offers a total profit metric.

Gross Margin
• Gross margin is a measure of profitability
that indicates how efficiently a company
produces its products or services. It is
calculated by subtracting the cost of goods
sold (COGS) from the total revenue and
then dividing the result by the total
revenue, expressed as a percentage.
• The gross margin represents the amount
of money left after accounting for the direct
costs associated with producing the goods
or services. It reflects the company's ability
to generate profit from its core operations
and is commonly used in industries where
the cost of goods sold is a significant
portion of the total revenue, such as
manufacturing or retail
Contribution Margin
• Contribution margin is a measure of
profitability that provides insight into the
profitability of individual products or
services. It represents the amount of
revenue remaining after deducting the
variable costs directly associated with
producing or delivering a specific product
or service. It is calculated by subtracting