Break Even Analysis Lecture 5 This lecture is part of Chapter 2: Budgets, Running a Company

Today’s Lecture Fixed versus Variable Costs Break Even Analysis Learn how to use the Solver in Excel

Break-Even Analysis An important part of running a company is the determination of how the company should be financed and how the prices of the products the company sells should be set. Clearly, in order to do this properly a sound financial analysis is necessary.

Types of costs It is essential to realize that there are two basic types of costs a company incurs. Variable Costs Fixed Costs Variable costs are roughly proportional to a company’s sales. I.e. the cost per unit remains roughly constant. Fixed costs remain roughly the same regardless of sales. I.e. the cost per unit is inversely proportional to sales.

Types of costs Total Costs Variable Costs Fixed Costs Sales Sales Value A simple graph but important to understand!

Break-Even Analysis Commonly, the Break-even point is defined to be the level of sales where: Revenues = Expenses Let us have a look at a simple example. Aunt Petunia opens a flower shop.

Break-Even Analysis Fixed Costs: Rent: 5,000 Utilities: 300 Helper: 1,500 Variable Costs: Flowers: 40% of selling price So we know that: Selling price – cost of flowers – rent – utilities – helper = 0 when she breaks even

Break Even Analysis Let’s enter the last line into the spread sheet We learned something in the last lesson. It’s good to put the assumptions separately. =E6*$H$7 But!!!?? I’m not a Mathematician! How am I going to find the value for E6 so that E11 = 0? =E6-E7-E8-E9-E10

Break Even Analysis Piece of cake! Trial and error! Oops! Not as easy as I thought. Especially if H7 is not a nice number like 40%. Is there a better way?

The Solver We could cave and write down the equation. That would, in fact not be such a bad idea since equations are really not as difficult to understand when one knows what they are supposed to mean. But *** RELIEF *** Excel has an incredibly useful function called the solver. It will solve equations without giving it the equations! That was close ….

The Solver The Solver can be found in the Tools menu of Excel. If it’s not there, it can be installed by going to the “Add- ins” menu item and selecting the Solver Add-in. This is really quite self- explanatory! Enter the appropriate values for “Set target cell”, “Equal to” and “By changing cells”, and click Solve.

Break Even Analysis Let try out the Solver! Incredible! Like this anyone can do Math! The break even point is 11,333

An Equation The Solver is a fabulous tool, but really in business it is beneficial to at least be open-minded about equations. Let’s give it a try! We know that: E11=E6-E7-E8-E9-E10 (Income = Sales – Cost – Rent – Utilities – Helper) At the break even point, Net Income = 0 and hence E11 = 0 Inserting this we obtain: 0 = E6-E7-E8-E9-E10

An Equation We want to change E6 such that 0 = E6-E7-E8-E9-E10 is true. Ah, if we just set E6 to the other values together the above equation is true. Or, E6 = E7+E8+E9+E10 is the solution to our problem. Let’s try it and go back to the situation before we used the solver:

Break Even Analysis Let’s fill the equation into cell E6 Oops! What went wrong? =E7+E8+E9+E10

An Equation May be Math isn’t as easy as I thought… But wait, doesn’t E7 depend on E6? Yes indeed, we have defined E7 = E6 * H7 (cost of product). Let’s put this into our equation: E6 = E7+E8+E9+E10 => E6 = E6*H7+E8+E9+E10 Or: E6 - E6*H7 = E8+E9+E10 E6 * (1 - H7) = E8+E9+E10 E6 = (E8+E9+E10) / (1 - H7)

Break Even Analysis Yosh! Let’s try that again. Yatta! It works After all, this was quite easy wasn’t it? And now we can change H7 to play out scenarios. Very useful indeed! (E8+E9+E10) / (1 - H7)

Break Even Analysis If Aunt Petunia raises the price so that the cost is only 30% of sales …. … she can break even already at Of course now she may be so expensive that no one wants to buy her flowers anymore.

The other way around There may be times when it is better to turn things around. Just now, Aunt Petunia found how much she needs to sell in order to break even given certain cost as percentage of sales. This is in general a good idea since for many products the profits are more or less set. In order to see how feasible a business is one could also enter an expected sales amount and then see how much the cost of the product can be in order to break even.

Break Even Analysis With our nice equation, it’s fairly easy to accomplish this: E6 * (1 - H7) = E8+E9+E10 (1 – H7) = (E8+E9+E10)/E6 H7 = 1 - (E8+E9+E10)/E6 Cool! And I thought that Financial Analysis is only for … others

Key Points of the Day The Solver is a great tool But Math can be very useful as well There are two types of costs: –Variable Costs –Fixed Costs Break Even Analysis is a snap with Excel