1. 1 Break-Even Analysis Prof. Dr. Dan Dumitru Popescu

2. 2 Main issues 1. Preparing Break-Even Analysis 2. Shifts in the Break-Even Point 3. Methods for calculating the Break-Even Point 4. Volume changes and Net Income 5. Target Net Profit Analysis 6. Margin of Safety 7. Operating Leverage 8. Multi-level Break-Even Analysis

3. 3 1. Preparing Break-Even Analysis The three main elements of a budget are as follows: Sales revenues Sales revenues Costs Costs Fixed costs Variable costs Semi-Variable costs Profits Profits Assumptions when preparing a break-even analysis: Selling prices do not change Selling prices do not change Total fixed expenses remain the same Total fixed expenses remain the same Variable expenses increase and decrease in direct proportion to sales Variable expenses increase and decrease in direct proportion to sales The “basic Break-Even Formula” is:

4. 4 1. Preparing Break-Even Analysis Calculating the break-even point for a retail business: S – sales in monetary units at break-even point FC – fixed costs or operating expenses VC – variable costs or cost of goods A more practical break-even formula can be derived as follows:

5. 5 1. Preparing Break-Even Analysis Calculating the break-even point using the Markup Percentage: Calculating the Break-even Point to a Service Provider: BE – volume of sales to break-even BE – volume of sales to break-even Fixed costs – fixed expenses, depreciation etc. Fixed costs – fixed expenses, depreciation etc. Variable costs – cost of sales and variable expenses Variable costs – cost of sales and variable expenses Calculating the Break-even Point for a Manufacturer:

6. 6 1. Preparing Break-Even Analysis ASSUMPTIONS: All of the output is sold All of the output is sold at the same price Variable costs are constant (no economies of scale) All information is not out of date

7. 7 2. Shifts in the Break-Even Point 2.1. Internal Factors -exp: increase in total costs (due to more staff) -exp: increase in total revenues (due to a price revenues (due to a price increase) increase)

8. 8 2. Shifts in the Break-Even Point 2.2. External Factors -exp: recession, the product would fall -exp: inflation would push up the variable cost

9. 9 3. Methods for calculating the Break-Even Point Contribution margin is the amount through which sales (net of variable expenses) contribute toward covering fixed expenses and then toward profits. 3.1. Equation Method Sales = Variable expenses + Fixed expenses + Profits 3.2. Equation Method The contribution margin ratio (CM) is the ratio of contribution margin to total sales expressed as a percentage.

10. 10 4. Volume changes and Net Income Note the following points: The contribution margin must first cover the fixed expenses. If the contribution margin is not sufficient to cover the fixed expenses, then a loss occurs for the period. As additional units are sold, the fixed expenses are whittled down little by little until they have all been covered. Once the break-even point is reached, net income increases by amount of the unit contribution margin for each additional unit sold.

11. 11 5. Target Net Profit Analysis The formulas used to compute the break-even point can also be used to determine the sales volume needed to meet a target net profit figure. Equation Method N = Number of units to attain the targeted net profit Y= Sales in m.u. to reach the targeted net profit figure Sales = Variable expenses + Fixed expenses + Profits  Price/unit x N = Variable exp./unit x N + Fixed exp. + Targeted Profit  Y = Variable exp. as a % of Selling price + Fixed exp. + Targeted Profit Contribution Method

12. 12 6. Margin of Safety The margin of safety (MS) is the excess of budgeted (or actual) sales over the break-even sales. It shows the amount by which sales can drop before losses begin to be incurred. Operating leverage is a measure of the mix of variable and fixed costs in a firm. The degree of operating leverage is not constant – it changes with the level of sales. 7. Operating Leverage

13. 13 8. Comparison between Capital-Intensive and Labor-Intensive Companies Element Capital-intensive (automated) company Labor-intensive company The CM ratio for a given product will tend to be relatively …HighLow Operating leverage will tend to be …HighLow In periods of increasing sales, net income will tend to increase … RapidlySlowly In periods of decreasing sale, net income will tend to decrease … RapidlySlowly The volatility of net income with changes in sales will tend to be … GreaterLess The break-even point will tend to be …HigherLower The MS at a given level of sales will tend to be …LowerHigher The latitude available to management in times of economic stress will tend to be … LessGreater The overall degree of risk associated with operating activities will tend to be … GreaterLess

14. 14 9. Multi-Product Break-Even analysis When there are multiple products, break-even analysis can be easily accomplished using the overall contribution margin ratio Ways to Lower Break-Even: 1.Lower direct costs, which will raise the gross margin 2.Exercise cost controls on the fixed expense, and lower the necessary total monetary units 3.Raise prices!