BREAK-EVEN ANALYSIS AND PLANNING 1

Break-Even Analysis and Planning

To begin with we would like to provide some background information about the

case under consideration. A meeting of senior managers at the Pringly Division has

been called to discuss the pricing strategy for a new product.

Part of the discussion will focus on estimating sales for the new product. Over the

past years, a number of new products have failed to meet their sales targets. It appears

that the company’s profit for the year will be lower than budget and the main reason for

this is the disappointing sales of new products.

A new technique for estimating the probability of achieving target sales and

profits will be discussed. This requires managers to estimate demand for the new

product and assign probabilities. A range, rather than only one goal will be established.

The first strategy is to set a selling price of $170 with annual fixed costs at

$20,000,000. A number of managers are in favour of this strategy, as they believe it is

important to reduce costs.

The second strategy is to increase spending on advertising and promotions and set

a selling price of $200. With the higher selling price the annual fixed costs would

increase to $25,000,000. The marketing department is adamant that increased emphasis

on advertising and promotions is essential.

The following probability distributions have been agreed with the managers after

consultation with all departments and are the same for both selling prices.

Estimated demand (units) Estimated probability (units)

150 000 0.25
180 000 0.5
200 000 0.25

Also, we have to provide some additional information:

1. The estimate or variable cost per unit is $30;

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2. The probability of the new product achieving break-even is very important. A

profit

greater than $4,000,000 is expected.

We have to conduct a break-even analysis for all the possible situations. It should

be done in order to discover what scenario is the most optimistic and what strategy

should be boosted. First of all, it would be reasonable to provide a definition of the term

“break-even analysis”. In our opinion, one of the most appropriate definitions of this

term is the following.

“Break-even analysis is a calculation of the approximate sales volume

required to just cover costs, below which production would be unprofitable

and above which it would be profitable. Break-even analysis focuses on the

relationship between fixed cost, variable cost, and profit” (Break-Even

Analysis Definition).

In other words, break-even analysis defines the amount of sales that creates

revenues enough to cover the costs associated with them. Thus, it defines the so-called

break-even point. It is a point, when the costs are equal to the revenues. Respectively,

the profit is equal to zero.

The company wants to conduct break-even analysis in order to define the pricing

strategy. A formal definition of the term “pricing strategy” is the following.

“Pricing strategy refers to method companies use to price their

products or services. Almost all companies, large or small, base the price of

their products and services on production, labour and advertising expenses

and then add on a certain percentage so they can make a profit. There are

several different pricing strategies, such as penetration pricing, price

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skimming, discount pricing, product life cycle pricing and even competitive

pricing” (Definition of Pricing Strategy).

As we can see from the definition, pricing strategy is based on the costs of

production. That is why it is very important to calculate what level of costs is going to

create the so-called zero profit.

Therefore, we have two possible selling prices and three possibilities. In the end,

we are going to be forced to calculate 6 break-even analysis. In order to make the

analysis easier we have to choose the most probable scenario – 180 000 units – and

prepare break-even analysis for the certain price and level of demand (units).

The first step is to define the sales for all the options of a selling price:

$170 $30 600 000

$200 $36 000 000

The next step is to compare the probable sales with the costs of production – fixed

and variables costs. This comparison should become a basis for the further break-even

analysis. This information and calculation are provided in the following table.

Price Sales Fixed costs Variable costs

$170 $30 600 000 $20 000 000 $5 400 000
$200 $36 000 000 $25 000 000 $5 400 000

The variable costs are going to be the same for the both situations, since they are

$30 per unit. The fixed costs are going to be different for the different situations,

scenarios. The following step would be defining of the possible profits for the both

scenarios. It can be achieved via subtraction of the total costs from the sales.

Sales Total costs Net revenues

$30 600 000 $25 400 000 $5 200 000
$36 000 000 $30 400 000 $5 600 000
As it can be seen from the table above, both scenarios are profitable. Also, the

profit is higher than $4 000 000 in both cases. That is why we can suppose that a new
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product is quite profitable. However, we should believe that the company’s forecasts

are reliable. As it has been already mentioned, the company had problems with the sales

forecast in the past.

On the other hand, the main goal of a break-even analysis is to calculate the so-

called break-even point. Break-even point can be calculated, using the following

formula:

Break-Even Point = FC/(1-VC/S), where

FC – is the fixed costs, VC – is the variable costs, S – are sales. The break-even

points for the both scenarios are provided in the following table:

Selling price Break-even point, USD Break-even points, units

$170 $16 400 000 96 471
$200 $21 250 000 106 250

Thus, we have calculated the break-even points for the both scenarios. Frankly

speaking, they are not too high for the both situations. It means that the company will

almost surely reach the zero profit. That is why it would be reasonable for the company

to launch a new product. Potential economic benefits are going to be much higher than

the initial costs.

Also, we can say that this type of analysis would be useful to a large company

with a wide range of products. However, it is going to be much complicated, since the

number of prices, volumes and scenarios is going to increase significantly.

Finally, we have to provide a definition of the term “return on investments” and

use it as an alternative for the break-even analysis. The most appropriate definition will

be the following.

“ROI is a performance measure used to evaluate the efficiency of

an investment or to compare the efficiency of a number of different investments.

To calculate ROI, the benefit (return) of an investment is divided by the cost of

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the investment; the result is expressed as a percentage or a ratio” (ROI

Definition).

ROI can be alternative for the break-even analysis. It characterizes profitability of

the investments by comparing the revenues from the initial costs. In our case, it can be

simply calculated by dividing the revenues by the initial costs. This information is

provided in the following table.

Selling price Net revenues Total costs ROI

$170 $5 200 000 $25 400 000 20.47%
$200 $5 600 000 $30 400 000 18.42%

Using this method of financial analysis we can say that the first option is more

profitable. That is why we would recommend it. This price is attractive for the

customers and more profitable for the company.

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References

Definition of Pricing Strategy. Retrieved March 5, 2012, from

http://smallbusiness.chron.com/definition-pricing-strategy-4686.html

Break-Even Analysis Definition. Retrieved March 5, 2012, from

http://www.investorwords.com/574/break_even_analysis.html

Break-Even Point. Retrieved March 5, 2012, from

http://www.accountingcoach.com/online

accounting-course/01Xpg01.html

ROI Definition. Retrieved March 5, 2012, from

http://www.investopedia.com/terms/r/returnoninvestment.asp#axzz1oGtUz200