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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

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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...

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