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Contribution Margin and Breakeven Analysis Simulation

Essay by   •  February 11, 2011  •  Research Paper  •  1,316 Words (6 Pages)  •  1,796 Views

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Contribution Margin and Breakeven Analysis Simulation

The contribution margin and breakeven analysis simulation of Aunt Connie's Cookies examines how the organization acquires and uses its resources for production in a given month. The budgeting decisions of CEO, Maria Villanueva, are challenged regarding cost control and the purchase of another plant as well as maintaining their market share. Estimating the contribution margin for each price of the cookies produced, and the marketing expense, could help Maria make an educated decision for profit optimization.

In considering whether or not to accept the large bulk order for one million Real Mint cookies at $1.2 per pack needed in one month, which on the average sold for $1.72 per pack, Maria should have considered the contribution margin. Maria had to consider the difference between the selling price of the cookie and the cost to produce the order as well as the sales revenue. Before accepting the large bulk order, Maria had to compare the total contribution margin and operating profit for the production of both the Lemon Crиme cookie and the Real Mint cookie. The sales revenue minus the variable costs and the operating profits for the production of the Lemon Crиme cookie is less than the Real Mint cookie.

Aunt Connie's Cookies can accept the bulk order and make a profit by reducing the current production volume for the Real Mint cookie instead of simply adding to the current production volume. If they want to increase the production volume of one of the cookies, it should be the Lemon Crиme cookie, which yields a greater contribution margin per unit. However, Maria should not accept the bulk order if the unit contribution margin for the Real Mint cookie had been greater than that of the Lemon Crиme cookie, and there was little to no idle current production capacity.

Maria is now considering the purchase of a peanut butter cookie, manufacturing unit from a competitor. According to the sales forecast, they need to produce 1.6 million packs of Lemon Crиme cookies in the current month. By purchasing the peanut butter cookie unit, Aunt Connie's Cookies can improve the baking process and utilize capacity to produce the quantity needed to meet the sales forecast on the Lemon Crиme cookies. This purchase will allow Maria to stay on her current production target of 1,000,000 Lemon Crиme cookies and produce the additional 600,000 Lemon Crиme cookies at the new unit reaching the breakeven point of 563,000 packs.

Breakeven sales volume is the amount of revenue needed to cover fixed and variable costs without a gain or loss. Aunt Connie's Cookies would not want to go beyond the breakeven point of production because it would affect the operating profits and suffer a loss in profits. If Maria decided to go beyond the breakeven point because the new unit could produce more cookies, then she would force the existing unit to reduce volume for Lemon Crиme cookies as they were exceeding the monthly production target. The variable cost per unit for making the Lemon Crиme cookies is higher in the new unit and will result in an overall reduction in profits. By maximizing the new plant capacity, the weighed-average unit contribution margin of the two products could optimize profits.

The three key learning points from the simulation are based on fixed costs, variable costs and breakeven points.

§ Fixed costs are the costs associated with a product or service such as the total monthly operating expenses (payroll and utilities) that do not vary with output production levels or sales volume.

§ Variable cost changes with the amount produced and are directly related to a product or service, such as cost of goods, some direct labor costs, shipping and raw materials.

§ Breakeven point to determines what volume of sales is needed for a company to break even on a product or generate zero profit. At the breakeven point the contribution margin is equal to fixed costs.

The simulation demonstrates how sales volume decreased when Aunt Connie's Cookies increased cookie prices. When the unit price of the cookies was decreased, the contribution margin per pack was reduced. The increase in sales was enough to offset the price reduction and increase the operating profits. The simulation shows how to keep the breakeven point of the large bulk order at a manageable level by increasing the company's overall gross margin, which is the difference between the selling price of the product and the production or manufacturing cost. Also increase the profit level on every sale, if the price can't be raised, then decrease variable costs or focus on products with the highest gross margin and cut overhead. By purchasing the peanut butter cookie unit, Aunt Connie's Cookies was taking on a higher degree of operating leverage. This creates more risk for the company even though

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