The objective is to achieve a desired “contribution” towards fixed costs and profit.
Contribution per unit can be defined as: SELLING PRICE less VARIABLE COSTS
Total contribution can be calculated as follows:
Contribution per unit v Sales Volume
The resulting profit in a business is, therefore:
Total Contribution less Total Fixed Costs
The break even level of sales can be calculated using this information as follows:
Break even volume = Total Fixed Costs / Contribution per Unit
Consider a business with the following costs and volumes for a single product:
| Fixed costs: | |
| Factory production costs | £750,000 |
| Research and development | £250,000 |
| Fixed selling costs | £550,000 |
| Administration and other overheads | £325,000 |
| Total fixed costs | £1,625,000 |
| Variable costs | |
| Variable cost per unit | £8.00 |
| Mark-Up | |
| Mark-up % required | 35% |
| Budgeted sale volumes (units) | 500,000 |
Prices are set using variable costing by determining a target contribution per unit. This reflects:
• Variable costs per unit
• Total fixed costs
• The desired level of target profit (i.e. contribution less fixed costs)
The variable/marginal costing method can be illustrated using the same data used further above:
• Assume that the selling price per unit is £12
• Variable costs per unit are £8
• The contribution per unit is, therefore, £4 (£12 less £8)
What is the break even volume for the business?
• Total fixed costs are £1,625,000
• To achieve break-even, therefore, the business needs to sell at least 406,250 units (each of which produces a contribution of £4)
Looked at another way, what would be the required sales volume to generate a profit of £250,000?
• Total contribution required = total fixed costs + required profit
• Total contribution = £1,625,000 + £250,000 = £1,875,000
• Contribution per unit = £4
• Sales volume required therefore = 468,750 (£1,875,000 / £4)
The advantages of using a variable/marginal costing method for pricing include the following:
• Good for short-term decision-making;
• Avoids having to make an arbitrary allocation of fixed costs and overheads;
• Focuses the business on what is required to achieve break-even
However, there are some potential disadvantages of using this method:
• There is a risk that the price set will not recover total fixed costs in the long term. Ultimately businesses must price their products that reflects the total costs of the business;
• It may be difficult to raise prices if the contribution per unit is set too low
http://tutor2u.net/business/marketing/pricing_variablecost.asp
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