In the case of serious marketing constraints the firm may be confronted with the problem whether to continue or shut down a particular unit of production for the time being with the help of break even analysis. It can be easily saved.
If the contribution from the product is positive, that is, contribution of the product will contribute something to cover the fixed overheads then it would be in business prudence to continue the unit rather than shut it down. Since the contribution is positive it reduces the burden of fixed overheads to the extent of contribution. To take an illustration:
In ABC Co, the department D has flowing results:
Fixed cost Rs 10,000
Selling price Rs 5.00 (p.u)
Variable cost Rs 4.80 (p.u)
Units sold 1,000 units
In such situation the contribution is Rs 0.20 p.u. so, gross contribution comes to Rs 200. If department D is shut down temporarily interest on Rs 10,000 must be borne by company,. But if continued the company would have to bear Rs 9,800.
To decide – make or Buy
The question most often confronted by industries, especially the assembly industry, is whether to make the particular component or part within the factory itself or purchase it from outside sources. This can be solved judicially with the help of break even analysis.
There can be two situations
1) The firm has sufficient excess capacity to process the component from within, so fixed overheads are not created.
2) Secondly, the firm to undertake installation of new machines and equipment necessary for the purpose of making the particular components at home.
In the case of (a) the contribution theory helps a lot If the prices at which it is available from the market are higher than the cost of making at home, then one must go in for making it.
A part can be procured from inside at Rs 10 and can be made at home for Rs 8 since no fixed overhead is involved, the contribution is positive and the decision is to make it.
In other cases, the component must be procured from outside dealers.
In the case of (b), it should be seen whether the volume required meets with the volume at break even point or not. If the requirement exceeds the volume to break even it would be advisable to make the component within the factory, otherwise it should be bought from outside agencies.
For instance, the firm requires 5,000 units of components A.
Fixed cost Rs 8,000
Variable cost Rs 10 (p.u)
Selling price (offering by outside agencies) Rs 12 (p.u)
BEP (units) = FC / Purchase Price – Variable Cost
= 8,000 / 12 – 10 = 4,000 units.
Here, to undertake the production of component A at the factory would be beneficial. However, one must note that other factors like secrecy of design, desire to exert control over production, technical competence etc have significant bearing upon the decision.
To decide – Add or Drop
The issue whether to incorporate a particular item in the sales unit in place for some other item can be well settled the use of break even analysis.
Here, for the given items of products we are to get the combined (total) contribution ratio for the different mix. The mix that yields a higher total contribution ratio is to be selected.
Here are the proposals before ABC Ltd – advise it.
Particulars Price Variable Overheads % of sales
A 60 40 30
B 100 60 20
C 200 120 50
A 60 40 50
D 160 60 10
C 200 120 40
For these proposals the contribution ratio is as follows:
Contribution ratio = Price – Variable Cost / Price x Percentage of Sales
(P / V ratio) Contribution ratio
For proposal (a):
A – 60 – 40 / 60 = 10%
B – 100 – 60 / 100 = 8%
C – 200 – 120 / 200 x 50 = 20%
Total Contribution ratio = 38%
For proposal (b)
A – 60 – 40 / 60 x 50 = 16.66%
D – 160 – 60 / 160 x 10 = 6.25%
C – 200 – 120 / 200 = 40 = 16.00%
Total contribution ratio = 38.91%
So, here proposal B carries higher total contributions ratio, so from proposal (a), drop the product B and add D, that would give better results.