Contribution margin operating income statement is a financial statement that is used in the budgetary control of costs. Management accountants are interested in distinguishing the proportion of the income that is generated by a single unit of production. There are many ways of classifying costs in cost accounting. Costs could either be categorized as the fixed cost or the variable costs. Variable costs are the costs that vary with the level of production within a relevant range. For instance, if the cost of producing one unit of clothing is $20, the cost of producing 10 units of such clothing should be $200.
On the other hand, the fixed costs are the costs that do not vary with the level of production within a certain range (Sinclair & Talbott, 1986). The costs are incurred regardless of the number of the units produced. For example, the rent of a manufacturing plant is $ 4000; failure to produce any unit will not defer the payment of the rent to the landlord. Most costs in production have an aspect of both the fixed and the variable cost. This essay will seek to explain the use of break even analysis in the production process and how it could be used to evaluate the level of activity in a firm.
The Concept of Break even Analysis
As mentioned in the above paragraphs, many costs in the firm can be broken down to fixed cost and the variable cost (Garbarino & Holland, 2009). In the production process, the firm must recover the fixed cost first in to before any gain is registered. Breakeven point shows the level at which the level of activity changes to yield a positive return. As such, it is the point at which the profit is equal to zero. This is the point at which the total contribution margin is equal to the fixed cost. Any unit sold above the breakeven quantity contributes to the recovery of the variable costs.
When a product is offered in the market, it is usually offered at a price higher than the cost of production. However, a firm must sell a certain number of units in order to cover the fixed cost (Pollack, 1995). As such, each unit of a product sold first contributes to the recouping of the fixed cost up to a certain point when the firm starts recovering the variable costs. Hence, the origin of term contribution margin in the production context.
Fixed costs cannot be allocated to a single unit of production as it is recognized for the entire department of cost centre and then apportioned to each unit of production (Powers, 1987). A product with a high selling price contributes more to the recovering of the fixed cost hence a low breakeven point. Before the breakeven point if attained, the firm operates under a loss as it cannot cover the fixed costs.
The Case of Hershey Company
Various break even analysis computations could be done to better understand the production efficiency of a firm. For instance, the difference between the cost of sales and total variable costs gives the contribution margin. If the total contribution margin is divided by the number of the units sold, the result is the contribution margin per unit.
The usefulness of the breakeven analysis in profit volume profit analysis cannot be overemphasized. Proper allocation of costs to the units of production is significant in measuring the used of breakeven analysis. Breakeven analysis can be used to in the choice of the product that a firm should choose for more profitability.
Garbarino, S., & Holland, J. (2009). Quantitative and Qualitative Methods in Impact Evaluation and Measuring Results. London: GSDRC.
Pollack, B. (1995). Break-even analysis: The third leg of the underwriting stool. Real Estate Review , 25, pp 43-6.
Powers, L. (1987). Break-even analysis with semi-fixed cost. Industrial Market Managemt , 67, pp 35-41.
Sinclair, K., & Talbott, J. (1986). Using break-even analysis when cost behavior is unknown. Managemt Accounting , 68, pp 52-5.