1.6.2 The relationship between revenue and costs

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    Contribution is the profit made on each product, it does not consider fixed costs. Fixed costs do not vary with output, so they are simply subtracted from total contribution. This gives the firm’s total profit or loss.

    Contribution = selling price – variable cost per unit.

    Total contribution = contribution x units sold

    This can be used to calculate the break-even point. The break-even point is the point where the firm’s costs are covered.

    Break-even point (units) = fixed costs/contribution per unit

     

                Break-even point (money) = sales price per unit x break-even point in units

    The margin of safety is the difference between the actual level of output and the break-even level of output. It indicates how much sales can fall by before the firm reaches the break-even point. A falling margin of safety is a bad thing for firms.

     

    LIMITATIONS OF BREAK-EVEN ANALYSIS

    The assumptions made for break-even analysis are:

    • The selling price per unit is constant and does not change with quantity produced
    • The variable cost per unit is the same
    • Fixed costs do not change with output
    • Everything produced is sold

    However, these assumptions are not always true, which limits the accuracy of break-even analysis.

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