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

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 Sales x100

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

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 Contribution x Sales

Wherein Contribution = Sales Variable Cost Alternatively, Break-even Point is Fixed Cost x 100 Contribution Margin

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

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, BreakEven Point in units (in terms of capacity utilization) can be computed as under: BEP (Sales in units) = Fixed Cost Selling price per unit Variable cost per unit

In another way, A break-even analysis shows, you when youve started to make a profit. One useful tool in tracking your businesss 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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 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 Lets use ABC Clothing as an example and compute this companys break-even sales for Years 1 and 2:
Break -even Sales for Year 1
=

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 its time to give up some of our toys and which, if any, we can afford to keep.

INTRODUCTION TO CORPORATE FINANCE

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

(Rs.1,70,000 + Rs.30,000) 0.25 (Rs.2,45,000 + Rs.30,000) 0.30

= Rs.8,00,000

Break -even Sales for Year 2 =

= Rs.9,16,667

not assets involving additional fixed costs.

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. Lets say the owner of ABC Clothing was confident he could generate sales of Rs.7,50,000 and the companys 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
=

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.

(Rs.170,000 + Rs. 30,000) Rs.750,000

= 26.7%

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, its 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 companys breakeven point.

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 youve 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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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 companys 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
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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.

INTRODUCTION TO CORPORATE FINANCE

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?

Note

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