||Break-even Analysis is concerned with the profit and cost structure
of a company and how these relate to the level of activity in the
business. It is a useful tool for the analyst to quantify the risks
under various business alternatives and to measure the prospective
results of management’s short-term decisions.
Break-even is defined as the point, or revenue level, at which losses
cease and profits begin. Profit, simply put, is the difference between
revenue and total costs:
Revenue = Costs + Profit (R=C+P)
We can break this down further by recognizing that all costs do
not change at the same rate and in the same way. The cost of an
increase in productive labour, for example, has no effect on the
depreciation cost of a machine, or on the rent paid for the building.
However, volume of production (or revenue) is one of the usual causal
factors in changing productive labour costs (more revenue may mean
you must hire additional staff). The depreciation expense and the
rent cost, on the other hand, are fixed with time.
Therefore, costs can be broken down into variable costs (varying
according to volume) and fixed costs (which remain constant up to
a certain revenue level or given unit of output).
Now, let’s take a second look at our revenue equation:
Revenue = Variable Costs + Fixed Costs + Profits (R=VC+FC+P)
Let us suppose that, in a business producing pots, 70%, or £0.70,
out of every sales pound represents the variable cost. Fixed costs
are £30,000. £0.30 pence (£1.00 - .70 = .30) out
of every sales pound will be left over to contribute to the coverage
of the fixed costs and profit. It follows that the number of units
that must be sold to break-even would be:
Clearly, any pots sold above the break-even level would mean that
the “contribution” would all go to profit, since the
fixed costs were already covered.
Now suppose that the company decided to do some additional advertising
to stimulate sales revenue, say an additional £9,000. Because
advertising is most often a commitment not based on volume, the
firm in effect would be increasing its fixed costs by that amount.
Thus the fixed costs would now be £39,000. Quite logically
this moves the break-even point further out. The contribution remains
the same so the new break-even point would be:
This means the company must sell an additional 30,000 pots (130,000
– 100,000) to reach the break-even point and begin making
a profit again. So what’s the decision? Well, the manager
would have to feel that the additional money spent on promotion
would indeed generate more than just 30,000 units before it would
be a wise move.
It must be added that we have looked at a quantitative measure for
examining alternatives. There may be other factors – qualitative
factors – that play a part in your final decision. Even though
a certain service in the short run provides a fairly low contribution,
you may still decide it is necessary because customers demand it
as part of their total package. Break-even/Contribution analysis
is often of considerable help in providing additional data for decision-making.
After that, it still becomes a matter of managerial judgement.
Analysts may also come across the term operational gearing when
they are looking at the cost structure of a company. An activity
with relatively high fixed costs to its variable costs is said to
have high operational gearing.