Contribution
- Contribution looks at whether an individual product or activity is helping the business to make a profit.
- If the sales revenue of a product is greater than the direct costs, the product is contributing towards either paying off the fixed costs or making a profit (if the fixed costs have already been covered).
Contribution Per unit: Selling price per unit - Variable cost per unit
e.g. if a pen cost 20p to make and they sell the candle for £1.00. The contribution per unit is 80p (£1.00 - 0.20p)
Total Contribution:
Contribution per unit x Number of units sold
OR
Total Sales Revenue - Variable Costs
Profit using contribution:
Total Contribution - Fixed Costs
Breakeven Analysis
Breakeven Analysis is: A study of the RELATIONSHIP between total costs and total revenue to identify the output at which a business breaks even (i.e. makes neither a profit nor a loss).
Breakeven Analysis makes the following assumptions:
- The selling price per unit stays the same, regardless of the number of units sold
- Fixed costs remain the same, regardless of the number of units of output.
- Variable costs per unit stay the same, regardless of output.
- Every unit of output that is produced is sold.
Calculating a Breakeven Output
1. Using a formula
Breakeven Output: The level of output at which total sales revenue is equal to total costs of production.
Example: £10,000
£1.00 - 0.20p = 12,500 units
2. Using a Graph - Break even chart
What is the Margin of Safety?
Definition: The difference between the actual output and the breakeven output.
This is like the firm's 'safety net'.
Changes to the breakeven Chart
How to lower the breakeven Output
1. Lower Fixed Costs
e.g. Lower rent (move to an area which is cheaper) or Lower Salaries.
HOWEVER - Less footfall, decreasing salaries could decrease motivation, workers could leave, replacement workers may not be as good at their job.
2. Lower Variable Costs
e.g. Use cheaper raw materials, pay workers lower wages
HOWEVER- Decrease Quality, Decrease motivation of workers
3. Increase Sales Revenue
e.g. Increase selling price or sell more products
HOWEVER - A higher price can reduce demand, promotional costs in order to sell more.
Usefulness of Breakeven Analysis to a start-up Business
- A new firm can use breakeven analysis to calculate how long it will take to reach the level of output needed to make a profit. Is the business viable? Useful if likely to have cash-flow problems as business can predict its profit level . Can help gain financial support, such as a bank overdraft.
- Simple and straightforward way to prove a business plan will succeed financially. Can also show the margin of safety. For example, if sales forecasts are optimistic, the business can calculate how much sales can fall before it drops below the quantity needed to breakeven.
- This data can be used as a key element in persuading bank managers or investors to give financial support to the start up.
- Will be used to plan its expected results, a 'best case' scenario and a 'worst case' scenario - the MAX and MIN level of profit to be made. Can indicate the level of risk involved in the start-up.
- Allows a firm to use 'what if?' analysis. Show different breakeven outputs and changes in profit level that could arise from changes in price or fixed costs or variable costs. Business can ascertain most profitable price or if business is feasible. Can also be done on individual products/services.
Strengths of Breakeven Analysis
1. Can show the different levels of profit arising from the various levels of output and sales that might be achieved --> Can predict profit levels (if number of units sold is known) --> This can help the business to plan its future objectives and strategies.
2. The calculations are quick and easy to complete --> saving business time --> Possible Inaccuracy? --> But is a quick ESTIMATE before they decide whether to go ahead.
3. Can foresee future changes --> e.g. Higher wage costs or lower prices --> Examine impact on individual product in range --> May be successful now but vulnerable in the future (or vice versa)
4. Used to discover point where a particular target profit level is made --> Must calculate target profit output by adding the target profit to fixed costs.
Weaknesses of Breakeven Analysis
1. Information may be unreliable --> Based on forecasts --> Even with market research it is difficult to predict the number of customers who will buy from the firm --> Or actual production costs could change (esp. if there is a break down of equipment or shortage of raw materials).
2. Sales are unlikely to be exactly the same as output --> Likely that some output will remain unsold (esp. perishable goods) --> Wastage of raw materials
3. In practice, the selling price might change as more is bought and sold --> Or will the firm have a fixed selling price?
4. Fixed Costs may not stay the same as output changes --> At particular levels of output new machines and even new buildings may need to be purchased.
5. Analysis assumes that variable costs per unit are always the same --> Ignoring factors such as bulk buying
Price
Definition: the amount paid by a consumer to purchase 1 unit of a product.
A business must set a price that is:
- High enough to cover the costs of making the product
- Low enough to attract customers
Total Revenue
Definition: A measure of the income received from an organisation's activities.
Total Revenue= Quantity of units sold x Price per unit
Also called: Income, revenue, sales revenue, sales turnover or turnover.
Profit
Definition: The difference between the income of a business and its total costs.
Profit= Total Revenue - Total Costs
Ways to improve profit:
- Increase sales revenue
- Decrease Costs
Costs
1. Total Costs Definition: The sum of fixed costs and variable costs
Total Costs= Fixed Costs + Variable Costs
2. Fixed Costs Definition: Costs that DO NOT VARY directly with output in the short run (e.g. rent)
Fixed Costs: Machinery, Rent and rates, Salaries, Administration, Vehicles, Marketing, Lighting and heating
3. Variable Costs definition: Costs that DO VARY directly with output in the short run (e.g. raw materials)
Variable Costs: Raw materials, Wages of operatives/direct labour, Power
Wages and salaries?
Wages are paid to operatives who make the product - measured per hour - a variable cost
Salaries are paid to staff who are not directly involved in production - measured per annum - a fixed cost
Semi-variable costs
Semi-variable costs are costs that combine elements of fixed and variable costs.
Example: A worker may be paid a set wage plus a bonus for each extra item she produced.
The set wage is a fixed cost and the bonus is a variable cost.
Effect of changes in Output on Costs
The total costs are rising at a slower rate than output because only the variable costs are increasing as output increases.
When output changes by a certain %, the total variable costs will change by the same %.
Relationship between costs and price
In lots of industries, increases in costs are 'passed on' to consumers in the form of higher prices.
These costs could be raw materials for example.
Business theory says this would lead to a fall in demand (and possibly sales revenue).
But demand is less likely to fall if every business increases its prices. This is likely when all firms are affected in the same way.
All firms will want to try and maintain a PROFIT MARGIN.
Profit Margin is the difference between the selling price of the item and the cost of making/buying that item).
Market
Definition: A place where buyers and sellers come together to exchange goods and services for money.
Geographical Classification
Based on the area targeted by a firm
Local Markets
Close to where the CONSUMER LIVES
e.g. A plumber, car boot sales, fruit stalls
National Markets
Selling goods across the COUNTRY
e.g. Nationwide Building Society, Thompson Holidays, Lloyds TSB - all sell across the country
International Markets
Trading in MORE than ONE COUNTRY
Not likely to be targeted by a business start-up (but there is now the danger of e-commerce)
e.g. McDonalds, Starbucks, KFC
Physical/Non-physical Markets
Physical Markets:
- "Traditional"
- A tangible place where buyers and sellers meet (e.g. A shop)
- Products can be seen and felt before purchase
Non-physical Markets:
- "Electronic"
- Uses modern Technology
- E.g. selling via the telephone or internet
- Allows a business start-up to compete on a national Scale.
Other Classifications of Markets
1. Market Segmentation
- According to the TYPE of customer
2. Competition in the Market
-HOW MUCH competition there is in the market
3. Nature of the Market
- The TYPE of MARKET the firm is in
- e.g. entertainment, fashion, gaming
Demand
Demand is: The amount of product or service that consumers are willing and able to buy at any given price over a period of time.
Factors Influencing Demand
1. Income and Wealth
- The ability of a consumer to purchase a product.
- Higher income -> Demand for products increase
- Pattern of demand changes -> Higher disposable income -> Consumers more likely to spend money on luxury goods.
2. Price
- If price rises, Demand generally falls
-Alternatives available
- Not so many 'impulse buys' - a higher price makes you think about it!
- Price elastic
e.g Chocolate bars, Luxuries
Model Answer
Explain one factor that affects the demand of a Santa Hat (4)
One factor is the price. As the price of the Santa hat rises, the demand for it will usually fall. There are no specific brands of Santa hats, therefore sales are very dependant on price. The consumers would think more carefully about whether the product is required as it is not a necessity item. As it is not a necessity item it would have many close substitutes, therefore an increase in price will lead to quite a dramatic fall in the quantity demanded. This is the price elasticity of demand being demonstrated. Reversely, if the price was to fall, the demand would increase as people would buy your Santa hat rather than other ones as it is cheaper and so is seen as better value for money.
- Price may rise and demand is hardly affected
-Not so many alternatives are available
- Little difference to sales figures
- Price Inelastic
e.g. Petrol, Necessities
- Similar result for a fall in price - demand will generally increase
e.g. Easter Eggs
3. Marketing and Advertising
- Successful marketing and promotion can have a major impact upon the demand for a product/service.
- Public Relations (PR)
- Branding- Higher prices for 'better' brands = Added Value
4. Competitors Actions
- Price Changes
- If competitors prices drop, demand will decrease as consumer buys from competitors who are cheaper. And Vice Versa.
- Their Marketing strategies
e.g Marlboro's cigarettes Vs Benson and Hedges Gold Cigarettes
5. Tastes and Fashion
- Fashions and tastes change
- Clothing - A key market example
- Changes in taste on tangible items as well as intangible e.g. Coffee Shop experience
- Good market research needed to predict market trends and keeping track of changes.
- Fall in demand if there is a change in taste or fashion
6. Government Action
Governments can influence the demand for a product by:
- subsidising for it
- taxing it
e.g Marlboro Cigarettes are heavily taxed which therefore leads to a higher selling price.
- introducing legislation (e.g. seatbelts)
- using its own advertising campaigns to either encourage or discourage the purchase of a product.
- Bans - e.g. Banning advertising of cigarettes
7. Demographic Factors
- Factors related to the population
- UK population has grown --> increasing demand
- Changes in geographical spread of the population (e.g ethnic balance, size of households, age distribution of population) ---> This change has meant change in the types of product demanded.
e.g. Immigration has meant that Muslims may want Halal food or cultural food.
8. Price of other goods
- Close alternatives
- Lower priced substitutes will generally lead to a fall in demand of the original
e.g Coca Cola and Pepsi
- Good to use along side the original
- Affects each other - if the demand for one increases, it is likely to increase the other
e.g Price of DS console decreases, demand for DS games increase
9. Seasonal Factors
- e.g. Ice cream, pumpkins, Christmas stuff...
- Demand high in one season and that item is not wanted in another season.
Market Segmentation
Definition: The classification of CUSTOMERS or potential customers into groups or subgroups (market segments), each of which responds differently to different products or marketing approaches.
Types of Market Segmentation:
1. Demographic
- Age
- Gender
- Social Class
- Income
- House you live in - Residential
2. Geographic
- According to country or area of that country of current/potential consumers.
- e.g Theatre tickets in London, Walking boots in Scotland, Fake Spray tan in Essex.
3. Lifestyle
- Leisure Activities
- Car owner
- Children
- Eating Habits
4. Frequency of Purchase
- Are consumers a 'tryer' or a 'follower'?
- e.g Iphone 5
Market Mapping
Benefits are Market Mapping:
- Helps firms identify their closest rivals, so they can plan suitable competitive strategies.
- Helps to identify gaps or niches in the market, place for intro of a new product
- If carried out with market research, can discover public's view of its business/brand and competitors
- Help a firm reposition itself in a market
Market size, growth and share
Market Size
The VOLUME of sales of a product (e.g the number of TVs sold)
or
The VALUE of sales of a product (e.g The total revenue from TV sales)
Market Growth
Definition: The percentage change in sales (volume or value) over a period of time.
Percentage change= Difference X 100
Original
Factors influencing Market Growth:
- Economic Growth - If a country's wealth increases per annum, sales are likely to rise in any given market.
- The nature of the product- Markets dealing with luxury goods (e.g. jewellery) tends to grow more rapidly when growth is high. But can suffer severe cutbacks when people are worried about their living standards.
- Changes in taste and fashion- As lifestyles change, new products become more popular while others decline (e.g. Coke and Bottled Water or trend of home cooking)
- Social Changes- The way in which people live may influence product sales. e.g. ready meals for people working longer hours.
Market Share
The percentage of the total sales of a product or service held by one firm or brand.
Formula:
Market share is a good way to measure a company's success as it compares the firm's sales with its competitors.
A company's market share can only increase if the company performs better than its rivals.
