Complete Guide To Corporate Finance


Project Analysis And Valuation - Break-Even Analysis

Break-even analysis is used to determine the point at which revenue received equals the costs associated with receiving the revenue. Break-even analysis calculates what is known as a margin of safety, the amount that revenues exceed the break-even point. This is the amount that revenues can fall while still staying above the break-even point. Break-even analysis is a supply-side analysis; it only analyzes the costs of the sales. It does not analyze how demand may be affected at different price levels.

For example, if it costs $50 to produce a widget and there are fixed costs of $1,000, the break-even point for selling the widgets would be:

If selling for $100: 20 Widgets (Calculated as 1000/(100-50)=20)

If selling for $200: 7 Widgets (Calculated as 1000/(200-50)=6.7)

In this example, if someone sells the product for a higher price, the break-even point will come faster. What the analysis does not show is that it may be easier to sell 20 widgets at $100 each than seven widgets at $200 each. A demand-side analysis would give the seller that information.

The break-even point is the point at which gains equal losses. Reaching the break-even point is a business's first step toward profitability.

In conducting a break-even analysis, you need to know what your costs are. There are three types of costs: fixed, variable and semi-variable.

A fixed cost is a cost that does not change with an increase or decrease in the amount of goods or services produced. Fixed costs are expenses that a company must pay independent of any business activity. These costs are one of the main components of the total cost of a good or service. An example of a fixed cost would be a company's lease on a building. If a company has to pay $10,000 each month to cover the cost of the lease but does not manufacture anything during the month, the lease payment is still due in full.

In economics, a business can achieve economies of scale when it produces enough goods to spread fixed costs. For example, the $100,000 lease spread out over 100,000 widgets means that each widget carries with it $1 in fixed costs. If the company produces 200,000 widgets, the fixed cost per unit drops to 50 cents.

Variable costs are dependent on production output. They rise as production increases and fall as production decreases. Variable costs differ from fixed costs such as rent, advertising, insurance and office supplies, which tend to remain the same regardless of production output.

Variable costs can include direct material costs or direct labor costs necessary to complete a certain project. For example, a company may have variable costs associated with the packaging of one of its products. As the company moves more of this product, the costs for packaging will increase. Conversely, when fewer of these products are sold, the costs for packaging will decrease.

Semi-variable costs, also called semi-fixed costs, comprise a mixture of fixed and variable components. Costs are fixed for a set level of production or consumption then become variable after that level is exceeded. With semi-variable costs, greater levels of production increase total cost, but if no production occurs, then a fixed cost is still incurred.

Labor costs in a factory are semi-variable. The fixed portion is the wage paid to workers for their regular hours. The variable portion is the overtime pay they receive when they exceed their regular hours.

The next step in break-even analysis is determining what price to charge for your good or service. Let's look at some of the pricing strategies companies use.

With competition-driven pricing, the seller establishes its prices based on what its competitors charge. Competition-driven pricing focuses on determining a price that will achieve the most profitable market share and does not always mean that the price is identical to the competitions'. Determining how to profitably achieve the greatest market share without incurring excessive costs requires strategic decision making. The firm must focus not only on obtaining the largest market share, but in finding the combination of margin and market share that will be the most profitable in the long run.

Penetration pricing is a marketing strategy firms use to attract customers to a new product or service. This strategy means offering a low price for a new product or service during its debut in order to attract customers away from competitors. The goal of this pricing strategy is to make customers aware of the new product due to its lower price in the marketplace relative to rivals.

When applied correctly, penetration pricing can increase both market share and sales volume. High sales volume may then lead to lower production costs and higher inventory turnover, both of which are positive for any firm with fixed overhead.

The chief disadvantage of penetration pricing is that the increase in sales volume may not lead to a profit if prices are kept too low. As well, if the price is only an introductory campaign, customers may leave the brand once prices begin to rise to levels more in line with competitors' prices.

Variable cost-plus pricing is a pricing method in which the selling price is established by adding a markup to total variable costs. The expectation is that the markup will contribute to meeting all or a part of fixed costs and generate some level of profit. Variable cost-plus pricing is especially useful in competitive scenarios such as contract bidding, but is not suitable in situations where fixed costs are a major component of total costs.

For example, assume total variable costs for manufacturing one unit of a product are $10 and a markup of 50% is added. The selling price as determined by this variable cost-plus pricing method would be $15. If the contribution to fixed costs per unit is estimated at $4, then profit per unit would be $1.

With customer-driven pricing, the seller makes a pricing decision based on what the customer can justify paying given the value of the product or service from the consumer's perspective. To optimize this pricing strategy, companies need to consider how to best segment the market so that prices reflect the differences in value perceived by different types of consumers. Companies must ensure that there is a comprehensive understanding of the customer and what he or she values. A company will make the most money if they can figure out the maximum each customer will pay and charge them that amount.

Companies can charge high prices on some products relative to their production costs and consumers will still buy them. For example, movie theater popcorn is dramatically marked up compared to the grocery store equivalent, and bottled water is exponentially more expensive than tap water. Other products have very thin profit margins. (For more on this topic, see 6 Outrageously Overpriced Products.)

To learn more about pricing strategies, read 4 Pricing Strategies That Increase Your Spending, 2 Key Tactics Retailers Use To Increase Sales and The Pros And Cons Of Price Wars.

Once you know a company's production costs and its pricing strategy, you can project when it is likely to break even and when it is likely to generate a profit. If the product or service is new, it can be difficult to predict demand, which is a third factor in break-even analysis. If the company must sell 1,000 units to break even, there has to be a demand for 1,001 units before the company will see a profit. If expected demand is only 200 units, the product or service may be a bad investment. If the company is established and has a history of selling the same product or service, it may be able to predict demand more accurately and thus perform a more accurate break-even analysis.

For related reading, see Analyzing Retail Stocks, Measuring Company Efficiency and 3 Secrets Of Successful Companies.

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