BREAKEVEN ANALYSIS

I. OPERATING BREAKEVEN ANALYSIS

A. ASSUMPTIONS B. CLASSIFICATION OF COSTS C. CONTRIBUTION MARGIN D. DETERMINANTS OF BREAKEVEN E. OTHER TYPES OF BREAKEVEN 1.Financial Breakeven 2.Cash Breakeven

II. MARGIN OF SAFETY III. SALES MIX

IV. LIMITATIONS OF BREAKEVEN ANALYSIS

I. OPERATING BREAKEVEN ANALYSIS

Breakeven analysis deals with the effects on profits of changes in: 1.Fixed costs 2.Variable costs 3.Sales prices 4.Sales mix 5.Sales quantities
Operating Breakeven Point: TR=TC TR= TVC+ TFC Q x P =VxQ + TFC Q ( P-V) = TFC Qb= TFC / ( P-V) where Q = Quantity produced and sold P= price per unit V= variable cost per unit TFC= total fixed operating costs For each additional unit in volume above or below Qb, there is increasing profits or losses.

A. ASSUMPTIONS
Assumptions of linear breakeven analysis are:
1.Costs can be classified as fixed or variable 2.Price per unit is constant 3.There is only one product or if multiple products exist, sales mix remains constant 4.Everything produced is sold.No inventories exist. 5.Variable cost per unit is constant. 6.These assumptions hold within a relevant range. In the long run, all costs are variable so, the analysis covers a short time horizon.

B.CLASSIFICATION OF COSTS
Fixed costs: Depreciation, rent, insurance, salaries,general office expenses, interest expenses ( for financial breakeven) Variable costs: Labor, materials, comissions Semivariable costs: Sometimes exist but are assumed to be nonexistent.

C.CONTRIBUTION MARGIN
Contribution margin refers to the contribution of additional sales to the coverage of fixed expenses.Given that, fixed costs stay constant, the dollar amount of contribution magrin is the amount by which profit increases assuming P>V or P-V>0.
Contribution margin= P- V If a company increases sales by 2000 units and if contribution margin is $ 5 , profits will increase by $ 10,000. ( $ 5x 2000 units). If P< V, then increasing sales will compound the firms losses. If P > V but P< FC/unit, operations should continue since increasing production will reduce FC / unit.Additional sales will contribute to covering overhead while the company develops a strategy to increase sales above breakeven. Contribution margin ratio = TR-TC/ TR = 1 VC/TR = 1- V/ P If a firm produces more than one type of product, then breakeven is measured in dollars: TRb = TFC / ( 1- VC/TR) Profits = Total revenues x contribution margin ratio

D. DETERMINANTS AND USES OF BREAKEVEN

If all costs were variable, there would not be any breakeven problem. Breakeven analysis is generally used in: 1. new product decisions: to determine how large sales volume on a new product should be to break even on a project. 2. studying the effect of expansion in the level of operations ( TRb) 3. analysis of decisions related to automation where variable costs will be substituted by fixed costs. 4. pricing and cost decisions( e.g. given the target breakeven,price, variable cost per unit and other fixed expenses ,what is the maximum rent the firm can afford?) 5. estimating the amount of sales needed to obtain at a desired level of profit. Increase in fixed costs cause quantity breakeven to increase , holding other variables constant. However,it is the interaction of changes in fixed costs, price per unit and variable cost per unit that effects the level of breakeven. That is , if increase in Fixed costs < decrease in variable costs , then Qb decreases. Average variable cost per unit may rise or fall depending on whether output rises faster or slower than total variable costs.

E. OTHER TYPES OF BREAKEVEN

E.1.Financial Breakeven Financial Breakeven is the level of profits ( EBT) that sets earnings per share ( EPS) to zero.It is the level of EBIT that covers all fixed financial charges . ( EBIT = I) if no preferred stock exists. EBT= EBIT-I EPS = (EBIT I ) ( 1-T) / N = 0 EBIT breakeven= I + Dps/ (1- tax rate) where EBIT= Earnings before interest and taxes I = All fixed financial charges Dps= Dividends on preferred stock

EXAMPLE 1:
I.H.A. INC: has the following income statement: Net Sales $ 15,000 COGS 10,000 Gross profit 5,000 Selling, general&adm expenses 1,500 EBIT 3,500 Interest expense 2,000 EBT 1,500 Taxes 500 Net income 1,000 Expense Fixed portion COGS 2,500 Selling, Gen.&ADm.Exp. 750 Interest 2,000 Total $ 5,250 Variable portion 7,500 750 -----8,250 Total 10,000 1,500 2,000 13,500

A. Operating Breakeven : TRb= 3,250* / 1- (8,250/ 15,000) = 3,250/ (1-0.55) = $ 7,222 * All expenses except financial expenses are included. B .Financial Breakeven EBT breakeven = 5,250 / 1-0.55 =$ 11,667 If sales are $ 11,667 pretax profits will be zero, indicating that this is also the breakeven point for net income. This example illustrates that financial policies increase the breakeven point by $ 4,445,or by 62%.

E.2 Cash Breakeven

Cash breakeven analysis is useful in determining the risks of insolvency.If cash outlays are small even during periods of losses, the firm may be operating above the cash breakeven point.In this case ,the risk of insolvency is small and the firm has more chance to reach for high profits through high operating leverage. Cash Breakeven ( TRc)= Fixed Costs Noncash fixed charges / ( 1-VC/TR) The assumption is that all sales revenues are in cash ( No receivables) and all costs are paid in cash and that there are no inventories.

II. MARGIN OF SAFETY

The margin of safety may be expressed as the ratio of actual volume to the breakeven point, or as the ratio of the percent of the difference betwen sales and breakeven to sales

EXAMPLE II.
SALES BREAKEVEN $ $ FIRM A 100,000 75,000 FIRM B 100,000 60,000 B 166.7% 40%

Margin of Safety A 1. 133.3% * 2. 25%** * 100,000/75,000 **100,000-75,000/100,000 =25%

Firm A is operating closer to the breakeven point than B.Company A will face losses if sales drop by more than 25% while Company B will have profits until sales drop by more than 40%.Firm B has higher margin of safety.

III. PRODUCT MIX

New product decisions and/ or decisions regarding elimination of some products in the product line or decisions regarding how much to produce of each product in the product line are related to determining the sales mix of the company. Sales mix refers to the relative proportions of the products in the total sales of the company.

EXAMPLE III:
MAP INC. has the following sales mix: SALES Product 1 100 units x $10/unit= $ 1000 Product 2 75 units x $ 15/ unit = $ 1125 Total 175 units $ 2125 VARIABLE COSTS $7.5 x100 units=750 $10 x 75 units= 750 FIXED COSTS 100 250 SALES MIX 100/175= 57% 75/175 =43%

PRODUCT 1 PRODUCT 2

NET INCOME 150 125

CONTR. MARGIN $2.5/unit 5.0/ unit

Average price= 2125/ 175= $ 12.14 Average VC / unit = 1500/ 175= $ 8.57

Breakeven point for the whole firm: Qb= 350/ (12.14- 8.57)= 98 units
Breakeven for product 1 : Qb= 100/ 10-7.5= 40 units Breakeven for product 2: Qb= 250/ 15-10= 50 units

Breakeven for the firm is greater than the sum of the breakeven points for the products.This is the case when contribution margins of the products are different.If contribution margins of the products in the sales mix are equal, then the sum of the breakeven quantities of the products in the sales mix will be equal to that of the firm as a whole. This company produces more of the product with the lower contribution margin which causes the firms breakeven point to be higher than the case would be if produced more of the product with lower contribution margin.

LIMITATIONS OF LINEAR BREAKEVEN ANALYSIS

1. Constant price asumption may be valid in perfectly competitive markets where firms can sell more units at a given price without any need for price adjustments. However, some markets may face imperfect competition where prices have to be reduced to be able to sell more. 2. As the level of output rises, more workers are hired, overtime pay increases.This may cause variable costs to rise sharply. 3. Historical relations may not persist over time.So estimates of costs , profits and volume is subject to uncertainty which is not considered in linear breakeven analysis. 4. Breakeven is a short term analysis but this may be a limitation for long range planning. For example, the benefits of R&D investments are not realized in the short run. 5. Many costs are hard to categorize strictly as fixed or variable.