The objective of breakeven analysis is to determine the breakeven quantity of output by studying the relationships among the firm's cost structure, volume of output, and profit.
The breakeven quantity of output is the quantity of output, denominated in units, that results in an EBIT (earning before interest and taxes)) level equal to zero.
Use of this model enables the financial officer (1) to determine the quantity of output that must be sold to cover all operating costs, as distinct from financial costs, and (2) to calculate the EBIT that will be achieved at various output levels.
There are many applications of the breakeven approach. Some of these include: capital expenditure analysis, pricing policy, labor contract negotiations, cost structure, financing decisions.
A key decision in strategy formulation or appraisal is the pricing decision. Break-even analysis can be used as an aid to strategic price determination. This technique allows managers to determine the break-even point. The break-even point is the level of output where the firm starts to earn a profit.
The nature of this analysis is depicted in Figure 5-8. Such a chart has been prepared for the Pierce Grain Company.
The break-even model includes several major elements. These are:
- Fixed costs
- Fixed costs, also referred to as indirect costs, are expenses that do not change, regardless of the number of units manufactured. Some specific example of fixed costs are: the cost of administration, mortgage on building, insurance, property taxes, rent.
- Variable costs
- Variable costs are assumed to vary directly with the volume produced. Some examples of variable costs include: direct labor, direct materials, energy costs associated with the production area, freight costs for product erif
For firm A, the degree of operating leverage at 100 000 units to be 1.67.
This equation can also be applied to Firms B and C. When this is done, we find Bs degree of operating leverage at 100 000 units to be 2; Cs is 2.5. Thus, with a 10 percent increase in volume, C (the firm with the most operating leverage) will experience a profit increase of 25 percent. For the same 10 percent volume gain A, the firm with the least leverage, will have only 16.7 percent profit gain.
The calculation of the degree of operating leverage shows algebraically the same pattern that Figure 5-10 shows graphically.
As we saw break-even analysis is useful in determining the change in profits that accompanies a change in pricing and costs. However, linear cost-volume-profit analysis has limitations as a guide to managerial actions. It is especially weak in what it implies about the sales possibilities for the firm.
Linear cost-volume profit analysis is also deficient with regard to costs. Some changes in product mix (e. g., over time the products sold by the firm change in quality and quantity; additional plant and equipment may be required, increasing fixed costs) influence both the level and the slope of the cost function.