Sales Increases & Contribution Falls

In our break even graphs, the standard assumption is that as sales volumes increase, contribution increases.

Contribution rises as sales increase

Lets assume a business makes 40% contribution on its sales.

If sales are £500,000 then contribution is £200,000

If sales are £1,000,000 then contribution is £400,000

If sales are £2,000,000 then contribution is £800,000

Sales and contribution increase proportionately as straight lines, separated by the variable cost percentage of sales.

Cutting Selling Prices To Force Growth

Growth may be slow and the business owner may decide to cut prices to create faster growth.

Assuming variable costs stay the same,

A 10% reduction in selling price, reduces contribution from 40% to 33.3%

[If sales were 100 and variable costs 60 before the price cut, giving 40 contribution, then after the price reduction sales are 90, variable costs are still 60 and contribution is 30 or 33.3% of sales (30/90)]

Assume sales volume goes up by 20% because of the price reduction of 10%

Sales are now £1,080,000 – that’s the £1,000,000 plus the 20% increase in volume of £200,000 less the price reduction of 10% of the new £1.2 million.

Contribution at the original prices on £1,000,000 at 40% is £400,000

But after the growth strategy

Contribution on £1,080,000 at 33.3% is £360,000

Sales have increased by £200,000 in value but contribution has reduced by £40,000, despite the 20% increase in volume.

Don’t worry about the arithmetic, things will become clearer as you become more familiar with the Cost Volume Profit model.

Return to P1M3 How Profit Is Calculated

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