This website uses cookies to ensure you have the best experience. Learn more

Leverage Break Even Analysis

3116 words - 13 pages

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 ...view middle of the document...

1875. Therefore, to cover fixed costs plus depreciation, you need sales of 2.45 million/.1875 = $13.067 million. At this sales level, the firm will break even. More generally,

[pic]

Table below shows how the income statement looks with only $13.067 million of sales.

Figure below shows how the break-even point is determined. The 45-degree line shows accounting revenues. The cost line shows how costs vary with sales. If the store doesn’t sell a cent, it still incurs fixed costs and depreciation amounting to $2.45 million. Each extra dollar of sales adds $.8125 to these costs. When sales are $13.067 million, the two lines cross, indicating that costs equal revenues. For lower sales, revenues are less than costs and the project is in the red; for higher sales, revenues exceed costs and the project moves into the black.

Is a project that breaks even in accounting terms an acceptable investment? If you are not sure about the answer, here’s a possibly easier question. Would you be happy about an investment in a stock that after 5 years gave you a total rate of return of zero? We hope not. You might break even on such a stock but a zero return does not compensate you for the time value of money or the risk that you have taken.

TABLE : Income Statement, break-even sales volume

[pic]

FIGURE: Accounting break-even analysis

[pic]

A project that simply breaks even on an accounting basis gives you your money back but does not cover the opportunity cost of the capital tied up in the project. A project that breaks even in accounting terms will surely have a negative NPV.

Let’s check this with the superstore project. Suppose that in each year the store has sales of $13.067 million—just enough to break even on an accounting basis. What would be the cash flow from operations?

Cash flow from operations = profit after tax + depreciation

= 0 + $450,000 = $450,000

The initial investment is $5.4 million. In each of the next 12 years, the firm receives a cash flow of $450,000. So the firm gets its money back:

Total cash flow from operations = initial investment

12 × $450,000 = $5.4 million

But revenues are not sufficient to repay the opportunity cost of that $5.4 million investment. NPV is negative.

Example: Assume we are selling a product for $2 each. The variable cost associated with producing and selling the product is 60 cents. Assume that the fixed cost related to the product is $1000. What is the break even point?

Q= FC/(P-V)= 1000 / (2.00 - 0.60) = 715 units.

• In this example, the firm would have to sell (1000 / (2.00 - 0.60) = 715) 715 units to break even.

OPERATING LEVERAGE

A project’s break-even point depends on both its fixed costs, which do not vary with sales, and the profit on each extra sale. Managers often face a trade-off between these variables. For example, we typically think of rental expenses as fixed costs. But supermarket companies sometimes rent stores with contingent rent...

Other Papers Like Leverage Break-Even Analysis

Online Auction Essay

693 words - 3 pages Healthy Foods, Inc., sells 50- pound bags of grapes to the military for $10 a bag. The fixed costs of this operation are $80,000, while the variable costs of the grapes are $.10 per pound. a. what is the break-even point in bags b. calculate the profit of loss on 12,000 bags and on 25,000 bags. c. what is the degree of operating leverage change as the quantity sold increases? d. If healthy foods has an annual interest expense of $10,000

Financial Management Essay

2464 words - 10 pages in the economic conditions, sales, expenses, etc. The EBIT-EPS analysis helps to find out the impact of financial leverage on EPS (and ROE) for possible fluctuations in EBIT. Example: (A) Debt 60%, Equity 40% Situation 1 (poor) 50,000 500,000 300,000 45,000 5,000 2,500 2,500 20,000 0.125 .10.0% Situation 2 (Normal) 75,000 500,000 300,000 45,000 30,000 15,000 15,000 20,000 0.75 15.0% Situation 3 (Good) 100,000 500,000 300,000 45,000 55,000 27,500

The Lazy Mower: Is It Really Worth It

1057 words - 5 pages Mower project. Interpret each one. Price per unit = $1000 (upto 102,000 units) Variable cost per unit = $400 Annual Fixed Operating Cost = $1,620,000 (includes opportunity cost of rent) Depreciation = 2,000,000 (assuming straight line depreciation over 10 years) Accounting Break-Even = (Fixed Cost + Depreciation)/(Price – Variable Cost) = $(3,620,000/$600

Pittman Company

646 words - 3 pages CASE 4–33 Cost Structure; Target Profit and Break-Even Analysis [LO4, LO5, LO6] Pittman Company is a small but growing manufacturer of telecommunications equipment. The company has no sales force of its own; rather, it relies completely on independent sales agents to market its products. These agents are paid a commission of 15% of selling price for all items sold. Barbara Cheney, Pittman's controller, has just prepared the company's budgeted

Cost Volume Profit

616 words - 3 pages CASE 4–33 Cost Structure; Target Profit and Break-Even Analysis [LO4, LO5, LO6] Pittman Company is a small but growing manufacturer of telecommunications equipment. The company has no sales force of its own; rather, it relies completely on independent sales agents to market its products. These agents are paid a commission of 15% of selling price for all items sold. Barbara Cheney, Pittman's controller, has just prepared the company's budgeted

Albatross Anchor Unit 2

1181 words - 5 pages be adopted for two reasons: (1) The break-even point for process B is 63291 units which is less than that of process A at 72,222 units, so process B is more cost effective. (2) Process B is also better than Process A in terms of the Operating leverage which can be defined as the change in net income per unit increase in sales volume Operating Leverage = F/(vx*) where x* is units

Cost Profit Analysis

2391 words - 10 pages will increase the company’s operating leverage and risk. 3-23 CVP analysis, sensitivity analysis. 1. CMU = $30−$21−(0.05 × $30) = $7.50 Q = [pic] = [pic] = 200,000 pairs Note: No income taxes are paid at the breakeven point because operating income is $0. 2a. Q = [pic] = [pic] = [pic] = 260,000 pairs 2b. Target operating income =[pic]$600,000 [pic]=[pic] = 280,000 pairs 3a

Week 2 Questions

816 words - 4 pages = $18.75 million / $10 per unit = 1,875,000 units 15-13A. (Break-even point and operating leverage) Allison Radios manufactures a complete line of radio and communication equipment for law enforcement agencies. The average selling price of its finished product is $180 per unit. The variable cost for these same units is $126. Allison Radios incurs fixed costs of $540,000 per year. a. What is the break-even point in units for the company

Nou La Munca

2318 words - 10 pages = (Fixed expenses + Target profit) / Unit contribution margin Dollar sales to attain target profit = (Fixed expenses + Target profit) / Contribution margin ratio Margin of safety = Total budgeted or actual sales - Break even sales Margin of safety percentage or margin of safety ratio = Margin of safety / Total budgeted or actual sales Degree of operating leverage = Contribution margin / Net operating income Cost-Volume-Profit (CVP) analysis is

Accounting

4202 words - 17 pages contribution margin will result in a dollar increase in net operating income. The CM ratio can also be used in break-even analysis. Therefore, knowledge of a product’s CM ratio is extremely helpful in forecasting contribution margin and net operating income. 6-2 Incremental analysis focuses on the changes in revenues and costs that will result from a particular action. 6-3 All other things equal, Company B, with its higher fixed costs and lower

Btec Business, L3, Unit 7, D1

1252 words - 6 pages Introduction In this assignment, I will evaluate the reliability of break-even analysis in estimating budgeted activity levels for a selected organisation. Break – Even Analysis Break even analysis is reliable as it is made from the budget and it gives a financial structure to the business. The data used for break-even, the business try to make the data as accurate as possible. They make this data depending on the previous year’s financial

Related Essays

Break Even Analysis

1096 words - 5 pages Break-Even Analysis ACC/561 CVP and Break-Even Analysis A CVP Analysis will classify the cost as variable and fixed, and calculates a contribution margin. Information in the analysis is the total monthly fixed costs of Snap Fitness, which are $6,000. Monthly fixed Operating costs are $4,000 and leasing equipment costs are $2,000. The center charges a monthly fee of $26 with no contract. Management needs to

Finance 3000 Essay

5825 words - 24 pages of using debt in the business.  TRUE 101. Sales commissions and raw material are variable costs.  TRUE  102. The contribution margin is equal to price per unit minus total costs per unit.  FALSE   103. As the contribution margin rises, the breakeven point goes down.  TRUE    104. Linear break-even analysis assumes that costs are linear functions of volume.  TRUE  105. Linear breakeven analysis and operating leverage are only

Cost Descriptions Paper

891 words - 4 pages price minus variable cost per unit” (Block & Hirt, 2005, p. 647). A break even analysis, “is the point where total revenue received equals the total costs associated with the sale of the product (TR=TC)” (Wikipedia, 2008, ¶1). Fixed and variable costs are used in this analysis to determine how much the organization needs to sell in order to be equal to the costs that were put into the product, hence the term break even. The analysis also

Cost Accounting Essay

1210 words - 5 pages average contribution margin. 7. Define and explain the relationship between margin of safety and degree of operating leverage. Margin of safety is the difference between actual or projected sales and break-even level sales. Margin of safety can be expressed in units, in dollars and/ or as a percentage of total sales dollars. It identifies the amount by which sales could fall and still leave the firm's bottom line in the black. Margin of safety