Leverage Break-Even Analysis

BREAK-EVEN ANALYSIS

Break-even analysis determine the the level of sales at which the total revenues are equal to total cost. That is, at this point there is no profit or loss. Managers most often focus on the break-even level of sales. However, you might also look at other variables, for example, at how high costs could be before the project goes into the red.

Most often, the break-even condition is defined in terms of accounting profits. More properly, however, it should be defined in terms of net present value. We will start with accounting break-even, show that it can lead you astray, and then show how NPV break-even can be used as an alternative.

BREAK-EVEN ANALYSIS: Analysis of the level of sales at which the company breaks even.

The break-even point for a product is the point where total revenue received equals the total costs associated with the sale of the product (TR=TC).

TR=TC

P*Q=TFC+V*Q

Q= TFC/(P-V)

Q= Amount of sales

TFC= Total fixed cost

V= Unit variable cost

P= Unit selling price

P-V= Unit Contribution

ACCOUNTING BREAK-EVEN ANALYSIS

The accounting break-even point is the level of sales at which profits are zero or, equivalently, at which total revenues equal total costs. As we have seen, some costs are fixed regardless of the level of output. Other costs vary with the level of output.

When you first analyzed the superstore project, you came up with the following estimates:

[pic]

Notice that variable costs are 81.25 percent of sales. So, for each additional dollar of sales, costs increase by only $.8125. We can easily determine how much business the superstore needs to attract to avoid losses. If the store sells nothing, the income statement will show fixed costs of $2 million and depreciation of $450,000. Thus there will be a loss of $2.45 million. Each dollar of sales reduces this loss by $1.00 – $.8125 = $.1875. Therefore, to cover fixed costs plus depreciation, you need sales of 2.45...