The Breakeven Analysis (CVP Analysis / Profit Contribution Analysis)

and Operating Leverage

Break-even analysis?

A decision-making aid that enables a manager to determine whether a particular volume of sales will result in losses or profits

The theory behind the breakeven analysis

Made up of four basic concepts

Fixed costs- costs that do not change

Variable costs- costs that rise in proportion to production (sales)

Revenue- the total income received

Profit- the money you have after subtracting fixed and variable cost from revenue

What can it be used for?

Monthly expenses- use it to see if your income is more then your expenses

Determine minimum price product can be sold for

Determine optimum price product can be sold for

Calculate effects of marketing programs on price

Breakeven formula

SP(X) = FC + VC(X) or TR = TC

F.C. = fixed costsV.C. = variable costs per unitX = volume of output (in units)S.P. = price per unit

This chart shows that the breakeven point is where the income and costs are equal

Breakeven formula cont.

If we rearrange the where the breakeven is X then the formula looks like this.

BEQ = FC /( SP – VC)Where, SP – VC = ContributionTherefore, BEQ = FC / Contribution

Margin of Safety = Actual Sales - Breakeven Sales

This formula says that the breakeven point is where the number of sales needed to make the cost equal to the revenue.

Example

Lets say you own a business selling burgers

It costs $1.00 to make one burgerThat’s your variable cost

You sell each burger for $2.80That’s your price per unit

Your cost for rent, utilities, overhead, etc... is $100,000 per month

That's your fixed cost

Example cont.

VC = $1.00 SP = $2.80 FC = $100,000

BEQ = F /( P – V)BEQ = 100,000 / ( 2.80 - 1 )BEQ = 100,000 / ( 1.80 )

BEQ = 55,555To breakeven you would need to sell 55,555 burgers

Problem

You own a lemonade standIt costs you $0.05 to make cup of lemonadeYou sell your lemonade for $0.25It cost you $50.00 to make the stand How many cups of lemonade do you have to sell to

breakeven?

Answer

BEQ = FC /( SP – VC) = 50 / ( .25 - .05 ) = 50/ ( .20 )

=250 units

Therefore, 250 cups of lemonade to be sold to reach breakeven.

A Breakeven Analysis is a simple tool to use to determine if you have priced your product correctly

A Breakeven Analysis helps you calculate how much you need to sell before you begin to make a profit. You can also see how fixed costs, price, volume, and other factors affect your net profit.

Calculation of breakeven price:

Example:

ABC International wants to enter the market for yellow one-sided widgets. The fixed cost of manufacturing these widgets is $50,000, and the variable cost per unit is $5.00. ABC expects to sell 10,000 of the widgets. What shall be the break even price of the yellow one-sided widgets?

 

Calculation of breakeven price:($50,000 fixed costs / 10,000 units) + $5.00

variable cost= $10.00 break even price

Assuming that ABC actually sells 10,000 units in the period, $10.00 will be the price at which ABC breaks even.

Formula: BEP = (FC/Qty) + VC

Operating Leverage

Operating leverage is the ratio of a company's fixed costs to its variable costs

Formula:Operating Leverage = [Quantity x (Price – VC per Unit)] / Quantity x (Price - VC per Unit) - Fixed Operating Cost

Q(P-VC)/Q(P-VC) -FC

Example: A Company XYZ sold 1,000,000 widgets for $12 each. It has

$10,000,000 of fixed costs. (equipment, salaried personnel, etc.). It only costs $0.10 per unit to make each widget.

Operating Leverage

= 1,000,000 *($12 - $0.10) __________________________________________

[1,000,000*($12 - $0.10) ] – 10,000,000

= 6.26 or 626%This means that a 10% increase in revenues should yield 62.6% increase in operating income (10% * 6.26).

Why it Matters?In a sense, operating leverage is a means to

calculating a company's breakeven point.

However, it's also clear from the formula that companies with high operating leverage ratios can essentially make more money from incremental revenues than other companies, because they don't have to increase costs proportionately to make those sales

Accordingly, companies with high operating leverage ratios are poised to reap more benefits from good marketing, economic pickups, or other conditions that tend to boost sales.

Why it Matters?

Likewise, however, companies with high operating leverage are more vulnerable to declines in revenue, whether caused by macroeconomic events, poor decision-making, etc.

It is important to note that some industries require higher fixed costs than others. This is why comparing operating leverage is generally most meaningful among companies within the same industry, and the definition of a "high" or "low" ratio should be made within this context.