Break-Even Analysis

Break-Even Analysis

Introduction

Break-even analysis helps organizational managers analyze financial alternatives to determine the feasibility of startups and business projects. Depending on break-even analysis results, managers make critical organizational decisions such as new product development, equipment and machinery purchase, and pricing strategies, among others. Despite its many valuable benefits, a break-even analysis should not be used alone. The tool fails to factor in other business realities such as cash availability, other uses for surplus cash and labor, overall organizational capacity, and external business factors. Despite the few weaknesses, break-even analysis remains to be an essential tool in preliminary organizational decision-making.

Basketball Shoe Making Company Break-Even Analysis

Sales (total number of shoes sold in a month x selling price each shoe)	$100,000
Variable costs (40%)	$40,000
Contribution margin (Sales – Variable costs) (100000-40000)	$60,000
Fixed costs – given	$35,000
Operating income (Contribution margin – fixed cost) (60,000-35,000)	$25,000
Break-even point (fixed costs / contribution per unit) = 583 units	583 units

 

Revised Break-even after an extra $1,500 of advertising

Sales New Sales (new sales volume x selling price of each shoe) ((50% x 1,000) + 1,000) x $100	$150,000
Variable costs (original 40% + $2/pair) (Selling price x new variable cost/pair)	$42.00
Contribution margin (Sales – Variable Costs) (60,000-2)/1000	$58,000
Fixed costs (original fixed costs + additional marketing cost) (35,000 + 1,500)	$36,500
Operating income (Contribution margin – fixed cost) ($58,000-$36,500)	21,500
New Break-even point (fixed costs /New contribution per unit) = (36500/58) =629 units	629 units

Analysis

Benefits and Limitations of Break-Even Analysis

Break-even analysis (BEA) shows the relationship between cost, volume, and profits to determine the practical applications of cost functions. It helps in showing the relationship between the total cost and total sales volume in a business. Since it measures the relationship between cost and sales, it is one of the tools used in cost-volume analysis. The focus in BEA is the break-even point, which is a point where the total value of sales is equal to the total cost of sales incurred. Break-even analysis is a popular analysis tool used in both big organizations and even startups. Despite its benefits in a business, it also has some weaknesses (Tsorakidis et al., 2011).

Strengths 

Break-even analysis helps startup owners determine the profitability of the new business. Before setting up a new business, the prospective business owner must conduct a break-even analysis. The tool will help the owner estimate the actual cost and profits expected from the venture (Tsorakidis et al., 2011). Hence, one will not engage in a business that may eventually fail.

The tool also plays a critical role among businesses seeking to change their operational model. For instance, managers seeking to shift business focus from assembling to manufacturing must first determine the feasibility of the new model. A break-even analysis will offer key insight into cost expectations, revenue prospects, and profits to be expected before deciding to implement such a critical decision.

Also, break-even analysis plays a key role during new product launches. Since new product development involves huge capital investment and expenditures, it is critical to determine whether it will be profitable (Gutierrez & Dalsted, 1990). A break-even analysis will help the company determine if and where the product will break even.

Other benefits of break-even analysis include providing useful information to the management, including break-even points, safety margins, profit, and loss levels at different output levels. Managers also use break-even analysis to determine which decisions to make, including whether to buy new equipment or not and whether the business can sustainably shift to new locations. The margin of safety calculation is critical in forecasting important business variables.

Weaknesses

Despite its many useful applications, break-even analysis is also subject to some limitations. One such restriction is using different selling price variables at every break-even point (Tsorakidis et al., 2011). Thus, many calculations and charts may be needed if one needs to determine the level that gives profits at different selling prices.

Another weakness relates to the assumption of the total cost. Break-even analysis operates on constant costs, something that is not viable in real-world situations. There are many mistakes and a change in circumstances during the production process that may increase costs than expected (Tsorakidis et al., 2011). For instance, if sales increase to exceed a level currently covered by the current assets, more employees will need to be recruited to cater to increased activity. An increase in labor costs translates into an increase in variable costs. Also, as new investments occur, a point reaches where fixed assets will also increase. That shows that variable and fixed costs are not as constant as presumed during estimation.

Also, break-even analysis does not consider the impact of cost changes on the product quality. Besides, break-even analysis is not entirely applicable in the real world. That is so because there is no mathematical solution in the competitive environment. Prices may rise or fall depending on the competitive environment and the resultant demand.

What-If Analysis

Organizations use ‘what if’ analysis to determine the impact of organizational decisions. Initially, the first scenario prepared reflects the conventionally accepted assumptions regarding the future. Consequently, alternative scenarios are based on worst-best-case scenarios about the impact of various organizational decisions. On the one hand, the best scenario contains results that the organization will achieve if everything goes its way. On the other hand, the worst scenario delves into what happens if conditions are unfavorable to the organization. Worst-case scenarios considered in the ‘what if’ analysis include low sales, unfavorable global conditions, high interest rates, and general economic recession.

What if’ analysis can test decisions in an organization. Managers are typically optimistic when carrying out organizational decisions. However, research continues to prove that managers do not evaluate all decision outcomes; thus, some decisions may not achieve the expected results (Hassani & Hassani, 2016). ‘What if ‘analysis helps the manager consider what may happen if things do not turn as expected. For instance, the shoe company managers in the case above are optimistic a $ 1,500 investment in marketing will undoubtedly increase sales. What-if analysis, however, also considers negative outcomes and whether such an investment is worth the risk. The tool offers the best and worst possible outcomes, helping managers determine how to implement organizational decisions.

Moreover, scenario analysis considers the impact of external factors on business decisions. It starts with analyzing potential factors that will affect the decisions. Once these factors have been identified, the manager then looks into how they may affect profitability and returns resulting from implementing certain decisions. For instance, in the shoe company case, the proposed $ 1,500 investment in marketing can only bring positive results if everything goes the organization’s way. However, that may not always be the case since other factors such as audience reception, reach, nature of marketing message, and similar efforts by rivals will determine if the effort will succeed.

Also, the tool helps managers to make critical business decisions during uncertain times. Almost all organizational decisions have some degree of uncertainty in them, such that it is not possible to tell that a given decision will bring organizational success (Hassani & Hassani, 2016). To succeed, however, the managers must commit to a single but inflexible decision. That will enable managers to commit to one decision while remaining open to other options if circumstances change.

Despite the many useful applications of ‘what if’ analysis, the tool is not spared from business complexity. Scenario analysis does not necessarily get rid of business uncertainty but rather helps managers manage the business reality (Hassani  & Hassani, 2016). After analyzing possible strategies and narrowing them down to a single plan, managers often forget that the decision is still subject to an unknown future. Managers who narrow down to a single possibility, ignoring uncertainty in business, may eventually end up disappointed.

One example of a failed scenario analysis is the IBM Company which settled on projected sales based on single-point analysis. In the 1980s, IBM projected 295,000 personal computer sales based on the tool. Due to the low projected sales, the company shifted focus from PCs to mainframe computers (Broadbent, 2005). IBM later sold PC systems that were to be used in the process to Microsoft. However, PC sales reached a staggering 25 million units, 85 times more than IBM’s earlier projection. Despite IBM’s success in cloud computing, the strategic error still affects the company to date as it does not participate in the PC trade (Broadbent, 2005). Single-point forecasting is too risky in the dynamic business environment.

Breakeven Results Comparison (Shoe-Making Company Case)

The increase in advertisement expenses led to a corresponding increase in the break-even point. Ordinarily, a high break-even point is undesirable since the business will have to sell more to measure up to the initial cost (Gallo, 2014). That is not always the case if the increase in break-even point is accompanied by higher sales volume and profits. In the initial case before the advertisement, the profit margin per unit was $25.00. Although advertisement meant that the business incurred more costs, it also led to an increase in profit margins per unit to $33.

Another important factor in break-even analysis is the contribution margin. Before incurring costs on advertisement expenses, the contribution margin per unit was $60. However, the contribution margin dropped slightly to $58 after introducing advertisement costs. It would seem like a drop in contribution margin per unit means decreasing fortunes, but that is not the case. As much as the contribution margin was reduced, the company attained more overall sales, thus exceeding the contribution margin losses.

Managers consider gross profit during break-even analysis. That is so because comparing break-even points may not give a true reflection of the state of business. However, companies with a low break-even point have a chance to engage in activities that will boost customer outcomes (Gallo, 2014). On the other hand, those with a higher break-even point have limited opportunities to boost production (Gallo, 2014). Therefore, companies with a higher break-even point must be risk-averse and avoid errors in the future, an undesirable business situation.

The shoe company should proceed with the advertisement investment. Even with increased labor costs and marketing expenses, the firm will still profit due to a high sales volume. An increase in the break-even point does not necessarily mean that the company should abandon marketing efforts as long as the projected revenue exceeds expected costs.

Conclusion

Break-even analysis is an inevitable analytic tool in organizational decision-making. Apart from helping organizations make strategic decisions, break-even analysis is useful in determining the viability of startups and new product development projects. Managers seeking to change their organizations’ business models also conduct break-even analysis before pursuing the projects. Despite the many benefits of break-even point analysis, the tool has limitations, such as its inapplicability in real-world situations and wrong assumptions on costs. Calculating the break-even level at every selling price is also a time-consuming task, sometimes not practical. An improved form of break-even analysis is the ‘what if’ analysis that addresses both best and worst business scenarios, unlike BEP analysis, which only anticipates a favorable business environment. Nonetheless, neither scenario analysis nor BEP analysis eliminates the element of uncertainty from businesses. The tools can only be used to manage uncertainty not to eliminate inevitable business environment actors.

References

Tsorakidis, N., Papadoulos, S., Zerres, M., & Zerres, C. (2011). Break-even analysis. Bookboon.

Hassani, B., & Hassani, B. K. (2016). Scenario analysis in risk management. Springer      International Publishing Switzerland.

Gallo, A. (2014, November 2). A Quick Guide to Breakeven Analysis. Harvard Business Review. https://hbr.org/2014/07/a-quick-guide-to-breakeven-analysis

Gutierrez, P. H., & Dalsted, N. L. (1990). Break-even method of investment analysis (Doctoral dissertation, Colorado State University. Libraries).

Broadbent, V. (2005, April 4). How IBM misjudged the PC revolution. News.bbc.co.uk. http://news.bbc.co.uk/2/hi/business/4336253.stm

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Category change to writer: This is actually an accounting essay, not healthcare. Thank you for your assistance, and have a great day.

Assignment:
You are the plant accountant for a company that makes a popular brand of basketball shoes. Currently, your company sells 1,000 pairs of shoes each month for $100 apiece. The variable costs are 40% of sales, and the fixed costs are $35,000/month. The company’s advertising director is asking for an increase in her marketing budget of $1,500 per month. She plans to enhance her marketing campaign in a targeted area of the West Coast. She estimates that the additional advertising will result in a 50% increase in demand. In this situation, the additional advertising costs are considered a fixed cost. What is the impact of this request on the company’s operating income? On the other hand, the production manager believes that this increase in sales could put pressure on the production line. He estimates that there will need to be a $2.00 increase in labor costs per unit.

Consider the following:

Using the projected monthly income figure calculated above, how many units would the company need to sell to meet the initial monthly income figure?
What is the break-even sales volume needed?
Summarize the results of your analysis.
Respond to the following for this assignment:

How did you calculate the original operating income and break-even point before changes?
What is the new break-even point after including the effects of the increased advertising and higher variable costs?
Compare the two break-even results and make a recommendation on whether the company should change or not.

Be sure to show your breakeven analysis in a table in a Word document. Answer the questions above as part of your analysis. The assignment is 5 pages minimum. The breakeven analysis can be one page of the analysis. Assignments should follow APA formatting requirements.

Submitting your assignment in APA format means, at a minimum, you will need the following:

Title page: Remember the running head. The title should be in all capitals.
Length: 5 pages minimum including an abstract, introduction, and conclusion. It is important that you use the template provided for this essay to avoid errors and loss of points.
Abstract: This is a summary of your paper, not an introduction. Begin writing in the third person.
Body: This begins on the page following the title page and abstract page and must be double-spaced (be careful not to triple- or quadruple-space between paragraphs). The typeface should be 12-pt. Times Roman or 12-pt. Courier in regular black type. Do not use color, bold type, or italics except as required for APA-level headings and references. The deliverable length of the body of your paper for this assignment is 5 pages. In-body academic citations to support your decisions and analysis are required. A variety of academic sources is encouraged.
Reference page: References that align with your in-body academic sources are listed on the final page of your paper. The references must be in APA format using appropriate spacing, hanging indent, italics, and uppercase and lowercase usage as appropriate for the type of resource used. Remember, the Reference page is not a bibliography but a further listing of the abbreviated in-body citations used in the paper. Every referenced item must have a corresponding in-body citation