Margin is quite simple and states that a certain value of the production volume exists for which costs are accounted for, but profit is null. This critical production volume is calculated by applying the following formulae:
The Variable Cost per Unit is calculated as Total Variable Cost per Current Volume. Therefore, aggregate revenue (Quantity (Volume) x Price per Unit (P)) shall be equal to the Variable Cost per Unit x Quantity + Fixed Costs + Profit
Q x P=VCU x Q + FC + Profit
x (P -- VCU) = FC + Profit and Q = (FC + Profit) / (P -- VCU)
The critical point is reached when the Contribution Margin is equal to the Fixed Costs and Profit is zero, since the Contribution Margin the sum of the Fixed Costs and Profit.
The first point I think that needs to be maid is that the Contribution Margin is an artificial construction introduced to simplify the lives of people working with it. Actually, this simplification can only lead to a decrease in efficiency. Why should the Fixed Costs and the Profit be added? This approach is purely synthetic and may lead to the omission of certain important aspects regarding the evolution of Fixed Costs on one hand and of Profit on the other. Should Fixed Costs increase and the profit decrease, the contribution margin will remain constant, which may create confusion and cause financial officers to take wrong decisions, as they are not correctly informed.
I would suggest instead the use of an analytical method and the separate approach of each of the two components. Fixed Costs may be evaluated more accurately, on the long and short-term, and profit would no longer be reduced to an appendix of the Fixed Costs. Although this way of handling things would request additional accounting operations, I think it is a more suitable method to tackle the problems posed by the two components.
After all, Fixed Costs are not so fixed. Prices may have important variations on the medium and long terms, and price bubbles may even appear on the short-term. The recent oil shortage problems have already caused increases in energy prices, which, despite being considered fixed, have created serious problems for financial managers. If we should stick to a stable Contribution Margin, the increase of the Fixed Costs would be set-off by the decrease of the profit and, therefore, of the profit margin. Company performance would be affected only because of the simplified approach imposed by the use of the Contribution Margin concept.
The profit margin is compatible with important changes on the short-term. Company objectives often cause CFO's to take drastic measure in order to satisfy shareholders' demands, short-term growth policies or other similar actions. Suppose a law imposing a progressive profit taxed is emitted. Fiscal consultants may advise for the profit to be diminished and for tax deductible expenses to be maid, in order to avoid payment of higher taxes. The profit margin would suffer important modifications. How is this alteration easily integrated in the concept of Contribution Margin?
The conclusion of this first point is that Profit and Fixed Costs do not have a similar nature. Considering Fixed Costs "fixed" is a simplistic approach. Considering profit "fixed" is a naive approach. Adding the two "fixed" components is an almost useless action. What economic environment is so stable that the evolution of the two elements may be considered accurately predictable and reliable? Although applying this method may not cause any damage to a small family business, a large corporation cannot afford to simply add two numbers (Fixed Costs and Profit), and act only on the information provided by the total. It just isn't doable, because these elements have different natures.
The second point that I would like to make is that the concept of breakeven analysis does not necessarily dictate whether production of a certain object is interrupted or not, should the profit fall below zero. There are numerous reasons for which a company would choose to continue production because losses are set off by gains in promotion or in othe