Break Even Analysis

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INTRODUCTION TO CORPORATE FINANCE
LESSON 18:
BREAK - EVEN ANALYSIS
Learning Objectives
· To understand Break-even analysis.
· To know about various costs involved in cash flow.
Introduction
You have learnt about the investment decisions, cash flow & its
estimation along with the incremental analysis of the investments.
Having known about the proper investment, you will
be keen to know how early investments will start make profits.
In this lesson, you will understand the same by means of
Break-even analysis and its relevant information, which can be
adapted to any of the investments. So, you need to have a close
look into break-even analysis regularly.
The determination of break-even point of a firm is an important
factor in assessing its profitability. It is a valuable control
technique and planning device in any business enterprise. It
depicts the relation between total cost and total revenue ay at the
level of a particular output. If an entrepreneur is aware of the
product cost and its selling price, he can plan the volume of his
sale in order to achieve a certain level of profit. The break-even
point is determined as that point of sales volume at which the
total cost and total revenue are identical. This will facilitate you
address the following questions: -
· How do expenses (cost) behave in relation to volume of
production / sales?
· What minimum sales are to be achieved to reach the point
of no profit – no loss?
· How profits are sensitive to variations in sales?
· What is the quantum of business risk of unit?
· Whether the expansion or diversification reducing the
business or not?
Break-Even Analysis
To perform the break-even analysis behavioural classification of
cost is required. On the basis of behavioural classification cost
can be divided into variable, fixed and semi-variable cost.
Variable Costs
The cost that varies according to changes in volume of sales is
called variable cost. Cost of raw material, spares, power and fuel,
factory wages and other manufacturing expenses re examples of
variable cost.
Fixed Cost
Fixed cost remains fixed for a given level of output and period
of time viz, salaries, administrative expenses, occupancy
overheads like lighting. In deciding the particular cost as fixed
cost, you should look behaviour of the cost but not the
quantum of money.
Examples for the fixed cost will be rent of premises, depreciation
on fixed assets and interest on loan. All these costs though
vary year to year will be treated as fixed cost because these will
not vary with the sales. However, there are opinions that in
some of the cases the interest will be treated as variable cost and
in some cases the same will be treated as fixed cost. This is due
to the effect of interest on working capital. Since, now-a-days
working capital is being financed as demand loan, commercial
paper and bills. In such cases interest is a fixed cost.
Semi-variable Cost
These are costs, which are partly variable and fixed. Most
expenses fall under this category. Telephone expenses, repairs
and maintenance, administrative expenses, etc., are treated as
semi-variable costs.
Contribution Margin
The difference between sales and variable cost is called contribution.
Contribution margin is the relationship between
contribution and sales. It indicates the portion of amount for
fixed expenses. The decline in the ratio indicates that product is
losing the market; it may be due to general obsolescence that
occurs during the life cycle of the product.
Contribution Margin = Contribution x100
Sales
Definition
The simple definition of a break-even point is the volume of
sales needed for a business to generate zero profit.
Break-Even Point (Sales in Rs. = Fixed Cost x Sales
Contribution
Wherein Contribution = Sales – Variable Cost
Alternatively, Break-even Point is Fixed Cost x 100
Contribution Margin
Therefore a decline in break-even point annually is a good sign
of improvement.
Further, you may also need the cost data to be converted into
per unit basis, because you would like to know at what stage of
units of production break-even can be had. For this, Break-
Even Point in units (in terms of capacity utilization) can be
computed as under:
Fixed Cost
BEP (Sales in units) =
Selling price per unit –
Variable cost per unit
In another way, A break-even analysis shows, you when you’ve
started to make a profit. One useful tool in tracking your
business’s cash flow will be break-even analysis. It is a fairly
simple calculation and can prove very helpful in deciding
whether to make an equipment purchase or just to know how
close you are to your break-even level.
Here are the variables needed to compute a break-even sales
analysis:
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INTRODUCTION TO CORPORATE FINANCE
· Gross profit margin
· Operating expenses (less depreciation)
· Total of monthly debt payments for the year (annual debt
service)
Since we are dealing with cash flow and depreciation is a noncash
expense, it is subtracted from the operating expenses.
The break-even calculation for sales is:
Break-even Sales =
(Operating Expenses + Annual Debt Service)
Gross Profit Margin
Let’s use ABC Clothing as an example and compute this
company’s break-even sales for Years 1 and 2:
Break -even Sales for Year 1 = (Rs.1,70,000 + Rs.30,000) = Rs.8,00,000
0.25
Break -even Sales for Year 2 = (Rs.2,45,000 + Rs.30,000) = Rs.9,16,667
0.30
It is apparent from these calculations that ABC Clothing was
well ahead of break-even sales both in Year 1 (Rs.1 million
sales) and Year 2 (Rs.1.5 million).
Break-even analysis also can be used to calculate break-even sales
needed for the other variables in the equation. Let’s say the
owner of ABC Clothing was confident he could generate sales
of Rs.7,50,000 and the company’s operating expenses are
Rs.1,70,000 with Rs.30,000 in annual current maturities of
long-term debt. The break-even gross margin needed would be
calculated as follows:
Break-even gross margin = (Rs.170,000 + Rs.30,000) = 26.7%
Rs.750,000
Now, you can use ABC Clothing to determine the break-even
operating expenses. If we know that the gross profit margin is
25 percent, the sales are Rs.750,000 and the current maturities of
long-term debt are Rs.30,000, we can calculate the break-even
operating expenses as follows:
Break-even operating expenses =
(0.25 x Rs.7,50,000) - Rs.30,000 = Rs.1,57,500
Another question that arises in you mind is, how can you figure
out what will be the breakeven point?
The answer for the same is breakeven point. Every company has
one, though many are rather clueless as to what it is. For many,
it’s not even considered until that embarrassing meeting when
the banker or investor gets that serious look in his or her eye
and inquires about the company’s breakeven point.
Strategies for Break-even Point
There are two key strategies to keep your breakeven point at a
manageable level.
The first is to increase the company’s overall gross margin.
Simply put, increase your profit level on every sale. The most
obvious way to accomplish this is to raise prices, but for some
companies and products that is not an option. Instead they
should look to either decrease variable costs or concentrate more
heavily on the products with the highest gross margin.
The second way to manage the breakeven point is simply to cut
overhead. Nobody likes to do it, but if the company fails, then
all holdings will be lost anyway. If managed early enough, a
company can cut the fat without touching an ounce of the
bone. Often there is plenty of unnecessary overhead to be cut
without touching a single employee. How many dotcom jobs
could have been saved, if companies had simply served generic
coffee every morning instead of specially imported European
blends? We all want our companies to be happy, comfortable
places, but paying attention to our breakeven points can help
alert us when it’s time to give up some of our toys and which,
if any, we can afford to keep.
Utility of the Break-even Analysis
· It serves as the most useful and important tool to study cost
output-profit relationship at varying level of output.
· It is useful in reviewing pricing polices.
· It aids in planning capitalization of the enterprise.
· It provides the entrepreneurs decide whether to acquire or
not assets involving additional fixed costs.
Shortcomings of the Break-even Analysis
1. The Break-Even Point (BEP) is based on some
assumptions, such as sales price, costs, production, sales, etc.
The technique will be only of financial value unless all these
assumptions are well calculated. Besides, the technique is a
preliminary and supplementary tool in the whole exercise of
ratio analysis.
2. The technique is to provide cost-escalation as built-in
safeguard against increase in prices.
3. The proper analysis of various costs into fixed costs and
variable costs is very important. This is so because; some of
the items will neither fall under fixed costs nor under variable
costs. Hence, semi-variable costs may cast its effect on the
BEP. BEP may not prove useful to rapidly growing
enterprises and to enterprises that frequently change their
product mix.
4. It has limited utility in case of multi products.
5. It does not due cognizance of factors like uncertainty and
risk involved in estimates for costs, volume and profits.
6. It is not a patent toll for long Range Planning.
However, it is an important tool for the profitability analysis of
the new projects.
Conclusion
The breakeven point may seem like Business 101, yet it remains
an enigma to many companies and their management teams.
Any company that ignores the breakeven point runs the risk of
an early death and at the very least will encounter a lot of
unnecessary headaches later on. If you’ve never computed your
breakeven point, take a few minutes right now and perform
some basic calculations for the sake of your investors, your
employees, your customers and, most important, yourself.
Doing a little easy math now, can prevent having to do a lot of
hard math later.
If you sell a product:
1. Determine which items are your fixed costs. These cost the
same regardless of your sales volume (rent, salaries, utilities,
etc.).
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INTRODUCTION TO CORPORATE FINANCE
2. Identify your variable costs. These are the ones incurred
specifically to make and sell your product (materials,
commissions, etc.).
3. Add items that are neither fixed nor variable (advertising,
etc.).
4. Total these three categories.
5. Subtract your variable costs from your sales total to
determine your contribution margin percentage. Your total
fixed costs, divided by the contribution margin percentage,
give you your sales break-even point, in dollars. To get your
break-even point in products, divide the contribution margin
by your total number of units produced. Then divide your
total fixed costs by the contribution margin per unit.
If you sell a service:
1. Perform the first four steps.
2. Divide your total income by your total expenses. If your
income exceeds your expenses, you are profitable.
Points to Ponder
· The break-even analysis.
· Importance of break-even point sales in amount and units
of production.
· Utility of Break-even analysis.
· Development of strategy for balancing the break-even point.
Review Questions
1. Why we need to do break-even analysis?
2. Define Break-even Point?
3. How to calculate Break-even point of sales in units?
4. Explain what are questions arise during investment?
5. What the shortcomings of Break-even analysis?