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Contribution Margin, Limitations of Break Even Analysis

The Contribution Margin

            Price – AVC in the above equation represents the contribution margin. Thus the above equation can be written as

                        BE Point         =                      TFC                         
                                                           Contribution Margin

            The below diagram explains the contribution margin where TVC is the total variable cost. TFC (total fixed cost) is added to TVC in order to arrive at TC (Total Cost). The difference between TR and TVC is the contribution margin.

Illustration 1

Let us assume the following:

  1. Total Fixed Cost as $300
  2. Average Variable Cost as $24 and
  3.  Price P as $30

Now with these values, compute the BE Quantity

            BE Quantity    =            300   
                                               30 – 24

            =          300      = 50 units
                          6

Now, TR         =          P x Q

                        =          30 x 50

TR                   =          $1500

TC                   =          TFC + TVC = 300 + (24 x 50) = $ 1500

Thus BE point is 50 units where TR ($1500) = TC ($1500)

Postulations

  1. The cost and revenue functions are linear
  2. Total cost is divided into fixed and variable costs
  3. Fixed cost is constant
  4. Variable costs change proportionately with output
  5. The number of units produced and sold of the product is identical. It means that there is no opening or closing stock
  6. The sale price is constant
  7. Factor prices are constant
  8. Costs are affected only by the quantity produced
  9. There is no change in technology and productivity
  10. There is only one product. In case of multi-products, the product mix remains constant

Limitations of Break Even Analysis

  1. Constant Price

    The straight line TR curve assumes that every level of output can be sold at the same price. This is unrealistic for the reason that product prices do not remain constant as output hikes. In fact, they change frequently.

  1. Constant Cost

    It is also assumed that whatever the level of output, AVC remains the same. This suggests that there is no limit to output which the firm can produce. This is again highly unrealistic.

  1. Limitless Profits

    This analysis assumes that profits are a function of output. This suggests that profits increase without limit as the level of output rises. In fact this never happens for the reason profits are influenced by technological changes, improved management, higher productivity, changes in the scale of fixed factors etc.

  1. Ignores Selling Costs

    It is based only on production costs and neglects selling costs.

  1. Data Limitations

    As the BE analysis is based on accounting data, it suffers from such limitations of data as neglect of imputed costs, arbitrary depreciation estimates, inappropriate allocation of overhead costs etc.

  1. Limited Products

    This analysis is based on a limited range of products and area. The present day firm produces many products and has many departments or plants which cannot be lumped together and presented on a single BE chart. So the scope of this analysis is limited to a single product of a particular business firm.

  1. Short run Analysis

    The BEA can be used only during the short run. As such it is not an effective tool for the long run.

  1. Ignores Elasticity of Demand

    It ignores the concept of elasticity of demand and the possibility that different prices may lead to different levels of demand. It also ignores the principle of diminishing returns which every firm has to keep in view for breaking even

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