Page 103 - DMGT202_COST_AND_MANAGEMENT_ACCOUNTING

Cost and Management Accounting

Notes If the assumptions of constant price and average variable cost are relaxed, break even analysis
can still be applied, although the key relationship (total revenue and total cost) will not be linear
functions of output. Non-linear total revenue and cost functions are shown in Figure 6.6. The
cost function is conventional in the sense that at first costs increase but less than in proportion to

output and then increase more than in proportion to output. There are two break even points – L

and M. Note that profit which is the vertical distance between the total revenue and total cost
functions, is maximised at output rate Q*.

Of the two break even points, only the first, corresponding to output rate Q is relevant. When a
1
firm begins production, management usually expects to incur losses. But it is important to know

at what output rate the firm will go from a loss to a profit situation. In Figure 6.6 the fi rm would

want to get to the break even output rate Q as soon as possible and then of course, move to the
1

profit maximising rate Q*. However, the firm would not expand production beyond Q* because

this would result in a reduction of profi t.
Figure 6.6
TC
D Total revenue
Profit
Loss M
L
Revenue TFC
Cost

0 Q 1 Q* Q 2 Rate of
Output(Q)

Contribution Margin

In the short run, where many of the firms costs are fixed, businessmen are often interested in
determining the contribution additional sales make towards fixed costs and profi ts. Contribution

analysis provides this information. Total contribution profit is defined as the difference between

total revenues and total variable costs, which equals price less average variable cost on a per unit

basis. Figure 6.7 highlights the meaning of contribution profit. Total contribution profit, it can be

seen, is also equal to total net profit plus total fi xed costs.
Figure 6.7
D TR
Profit
Net Profit Total Contribution
Profit (TCP)
Break-even TC
Loss point
Fixed cost
TVC
Revenue
& Cost A
Variable cost

0 Q* Output(Q)

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