Breakeven Point Analysis for the Optimum Business Operation

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In financial management, there are concepts that are considered extremely important as having a profound effect on financial decision-making, on business value and on the financial stability of its owners in the long run. The concepts referred to as the fundamental building blocks of financial management are the concepts of shareholder value, risk and return and cash flows. Another important concept in financial management is the role of the financial markets as a source of company finance and in evaluating a company's securities. Mcmenamin (1999) added that the core concepts directed at achieving the firm's goals are reflected in the financial manager's activities and the outcomes of the firm's investment and financing decisions. An example of which is the changes in market interest rates that can influence the investment and financing decisions of the financial manager that essentially include the return on capital (pp. 4-5).

Boer (1999) presented return on capital as a dominant consideration in investing which is a represented as a fraction with the numerator as the profit and the denominator as the invested capital. To reap greater profits is to increase the numerator from the same amount of capital to improve the return. To reduce or control capital as reflected in the reduction of the denominator is also another way of improving return although this option is frequently overlooked. There are several decision-making tools that relate to operating capital and one of them is the break-even point analysis (p. 84). Break-even point analysis is a simple and powerful decision-making tool taking into accounts the fundamental differences between fixed and variable costs. Fixed costs are defined as those that do not change over an observable period, even as the level of production changes and are mostly capital related. Variable costs are defined as costs that increase more of less linearly with output that include raw materials, direct utilities, packaging, and shipping and direct labor. The term direct means direct contact with processing equipment. Variable costs are sometimes referred to as direct manufacturing cost or DMC. Though the distinction between fixed and variable cost is direct to the point, judgment is required in applying this useful concept and making it work to the business' advantage. Gross margin is referred to as the excess of revenue over variable costs that happens to represent cash received by the business as it linearly increases with sales. Below that the business is losing money (Boer, 1999, p. 86).

Managing a business is not an easy task. The challenges that come with the responsibility of ensuring the profitability of the business can take up most of the owner's time in pouring over the financial statements and projections. The challenges are even greater in big organizations where a number of products and services are being offered. A sound mind and body is a prerequisite to be able to take on the pressures of managing the business especially with financial management. Aside from this, the owner or manager must be knowledgeable in the concepts of financial management especially in analyzing the relationship between costs, revenue and profit. He or She must be able to determine the acceptable revenue to cover the calculated costs in producing the products or otherwise known as the break-even point.

This paper aims to provide concrete support in the use of break-even point analysis to achieve the optimum potential of a business. Also, it aims to provide a deeper understanding on how to use this method to any type of business with one or more products and services being offered in the scope of financial management and the benefits it provides to the owners and managers.

Background

Break-even analysis or cost-volume-profit (CVP) analysis is presented by Riahi-Belkaoui & Holzer (1986) as an established managerial tool that attempts to formulate a firm's cost and revenue functions and the relationships between the two (p. 63). This type of method segregates costs into fixed and variable components and examining the behavioral patterns of costs and revenue in relation to profit. The analysis also determines the level of activity of costs and revenue in equilibrium. It is considered as a normative model for understanding the relationships between the cost, revenue, and profit structures of a firm and is a key factor in all decisions based on selling prices, variable costs, and fixed costs. The conventional approach to break-even analysis is used to compute the break-even volume or level of activity for which the profit generated is zero and beyond which any increase in production will lead to positive results on profit. The break-even point corresponds to the volume of activity at which total revenues equal total costs. In other words:

r = P q - (F + V q)

where r = profit before income taxes,

P = unit selling price,

q = sales volume in units,

F = total fixed costs,

V = unit variable cost.

Break-even analysis as a risk investment analysis method

In dealing with risk in investment analysis, the break-even point method can be used as it is focused in capturing risk by using an appropriate discount rate or a certainty equivalent coefficient. This method presumes that the risk is relative to the required rate of return as it increases and it also determines how low an income variable can be or how high a cost variable can rise, before the project breaks even at a net present value of zero. Dayananda, et al. (2002) expresses that information about the critical variables allows management to make decisions at two points in time in the investment analysis where management can commit extra funds to develop more reliable forecasts for variables which will be critical to the venture's success during the planning phase. There are two different types of decisions made in the process. The decisions made during the planning stage are known as ex ante (before the event) decisions while ex post (after the event) decisions are the decisions made during the operating phase. In this phase, special attention to the behavior of identified critical variables is made by the management to ensure that the project behaves as expected (p. 133).

According to Badiru (1993), the use of break-even analysis helps a business in avoiding loss of money by determining the minimum production and sales amounts for a project. For projects, the break even point of an operation is defined as the value of a given parameter that will result in neither profit nor loss. Examples of parameter of interest may be the number of units produced, the number of hours of operation, the number of units of a resource type allocated, or any other measure of interest. At the break even point, we have the following relationship:

TR(x) = TC(x)

or

P(x) = 0.

In some cases, there may be a known mathematical relationship between cost and the parameter of interest like a linear cost relationship between the total cost of a project and the number of units produced. The cost expressions facilitate straightforward break even analysis (p. 197).

Break-even Analysis as a special application of Sensitivity Analysis

As an application of sensitivity analysis, break-even analysis aims to find the value of individual variables at which the project's net present value or NPV is zero. If the management wishes to how low the unit selling price can fall before the project becomes unsuccessful, they can decide to push through with the project or not with the use of break-even analysis. With the use of this method, two ways can be approached by the management. First way would be deciding on abandoning the project if forecasts show the likelihood of below break-even values while the second way is allowing the management to prepare for a worst-case scenario that involve the investigated variables being realized during the life of the project. This in turn, could lead to project suspension, improvement of the efficiency of production or the adjustment of the unit selling price. Dayananda, et al. (2002) present the following points to be considered in using the break-even analysis in decision-making:

The adjustments made on the variables should only be done one at a time though it is unlikely that only one variable will change during the project duration. To base the decisions on observing the behavior of only one variable will only make the decisions void.

The analysis on the variables should be done as if these are independent in nature. Variables in pairs like sales volume/sale price are not considered independent.

The project should be reviewed at regular points during its duration, with analyses taken referring to future events and not to past ones. The calculated break-even values at the onset may not be accurate thus, should be recalculated at the chosen point in time (p. 149).

Objectives of the Research Paper

The objectives of the paper are the following:

To be able to identify the components of break-even analysis

To be able to provide a straightforward explanation on the use of break-even analysis in businesses

To be able to provide a concise approach on break-even analysis as a decision-making tool

To be able to provide examples on how break-even analysis is applied with technology

To be able to determine limitations in using the method in financial management, decision-making and in managerial accounting

To be able to determine the relationship of break-even analysis with other methods used for financial management and management accounting

Literature Review

There are various written works on how the use of break-even point analysis is beneficial to an organization's financial status and its importance in the initial phase of decision-making. This method is also known by its other name, CVP or cost-volume-profit analysis as presented by Kee (2007). Thompson (1993) provided a direct approach of identifying the components in calculating for the break-even point that can be used for small and big businesses. These components include the following:

Fixed expenses: Costs those remain constant regardless of sales. Examples include rent, insurance, property taxes, general equipment maintenance, administrative salaries and interest on borrowed money.

Variable expenses: Costs that vary as sales volume increases or decreases. Examples include direct labor costs and related payroll taxes, costs of goods sold, sales commissions and delivery expenses.

Contribution margin: Sales profit.

Boer, Lewis, and Riahi-Belkaoui & Holzer are one with the use of break-even point analysis as a powerful tool that management can use in determining the relationship between costs, capital and revenue. Determining the relationship between the three factors will provide the management a clear view on the financial standing of the company and be able to identify workarounds or tasks to improve return with the least costs possible. Dayananda, et al. (2002) presents the method as pessimistic since it is the last line of defense of the management although it adds to the strength of project investigation. It is also considered limited since one variable is altered one at a time while the rest are held at their most likely values and in a dynamic world, many variables will be changing in different directions at the same time (pp. 149-151). Thompson (1993) also added that using the break-even analysis doesn't guarantee that your company will make a profit although it does serve as an excellent planning tool. Using this tool equips the owner with knowledge to plan on how the business can operate upon determining the minimum level of sales to carry on with the operation. He also added the simple formula works best with businesses that sell one product or offer one service. Modification on the formula to calculate the average cost and selling price would be essential when used in businesses that offer multiple products or services.

Shim & Siegel (2007) provides the need of using the break-even analysis in order to understand the nature and importance of operating leverage. Leverage is defined as the portion of fixed costs that represents a risk to the firm. Operating leverage is a measure of operating risk refers to the fixed operating costs found in the firm's income statement. Financial leverage, a measure of financial risk refers to the financing portion of the firm's assets, bearing fixed financing charges in hopes of increasing the return to the common stockholders. The higher the financial leverage, the higher the financial risk and the higher the cost of capital rises because it costs more to raise funds for a risky business (p. 306).

Thierauf (1999) presents the essential elements in writing a formal business plan. The plan should include an executive summary, a company overview, the products and services being offered, a market analysis, a marketing plan and a financial plan. The executive summary highlights the highlights the company's mission, measurable objectives and goals, product and marketing strategies, and the financial plan while the company overview sets the stage for the venture and provides details of its history and ownership, operating structure, management team, and business purpose. The products and services describe what the company sells and how it develops, produces, and distribute products and services and also include an analysis of competition and future plans. The market analysis describes current and potential customers and the demographics of the marketplace. In addition, the marketing plan reveals the company's strategy for reaching its markets through advertising, alliances, distribution channels, promotions, and a sales force. Finally, the financial plan sets the words to numbers and shows the recent operating history. It projects the next three to five years' worth of cash flow, profits, and asset and liability balances. It also typically contains a break-even analysis, financial ratios, capital requirements, and the timing and amount of the return on investment (p. 197).

With the presence of technological advancement, business planning software can be put into use to determine the company's overall financial performance. There is some software in existence today that provides monthly actual reports and budget reports that are regularly produced by today's information systems. A sophisticated business model known as the corporate scorecard software is being used by some companies today to help them understand the elements of their success. It works like a control panel that keeps track of the company's financial progress as well as its softer measurements like customer satisfaction (Thierauf, 1999, p. 197).

According to Primeaux & Fortin (1984), one of the founders of business economics and a major contributor on capital budgeting was Joel Dean. He published an article titled "Cost Structures of Enterprises and Break-Even Charts", an evaluation of breakeven analysis and its usefulness to management. The use of break-even charts used by management can increase the significance of empirically determined cost function was pointed out by this article. Dean also added that these charts have some serious limitations for forecasting profit brought about from the errors from estimating the true static cost function, the oversimplification of the static revenue function, the dynamic forces that shift and modify these functions, and the managerial adaptation to the altered environment. He believed that determining the firm's cost curves is the most difficult challenge when using the break-even analysis in cost research since the development of a good output index of a multiple product plant with variable product mix can have serious problems (pp. 25-26).

CVP analysis as a simple planning tool allowing managers to examine the possible impacts of a broad range of decisions is one of the most powerful techniques in managerial accounting. Its scope can be expanded by extending its basic model in order to mitigate its shortcomings. Examples of these limitations are the impact of strategic decisions on the firm's wealth, effects of these decisions on the asset structures and risk levels of the firms. These limitations should be incorporated in all CVP analyses as any managerial decisions made will affect the risk levels and costs of capital when the asset and cost structures of the businesses are altered. In reality, the world of managerial affairs is complicated and the use of a typical analytical model will eliminate most of the complications in order to preserve a sharp focus. The simplified structure of analytical models like the CVP analysis in addition to its limitations contradicts to its relevance and improving it will include broadening of its scope (Guidry, et al., 1998).

These compiled researches provide an overview on how break-even analysis can affect a business' outcome with regard to decision-making and analysis on the given variables relating to operations. The supplementary works provided in this paper also corroborates with the importance of the method, the identified limitations and disadvantages with its use. This paper also provides an overview on the presence of break-even analysis in coming up with a business plan with the use of business planning software available in the market.

Break-even Analysis as Cost volume profit Analysis

Business owners and regular people alike question the how cost behavior patterns can be used in managerial decision making. May et al (1975) offers a direct answer. They present the use of cost behavior implications of various activities and events in constructing an overall cost function for a decision alternative or decision variable. The cost function is then manipulated to generate decision-relevant information about the alternative or variable. Accountants are concerned with using cost behavior patterns to provide information about the alternative or variable while managerial decision making focus on the production and the sales of products and services. This type of application has the special label of cost-volume-profit analysis (sometimes called break-even analysis). Cost-volume-profit analysis is so frequently used in practice that it is a most appropriate context for acquainting the reader with the application of cost behavior patterns (p. 13). As Reid, et al. (1993) put it; break-even analysis can identify the output scale beyond which the service or product would inevitably be profitable (p. 41).

Kee (2007) refers the break-even analysis as cost volume profit analysis as one of the simplest analytical tools used in management accounting. As one of the widely used methods, it provides a direct financial overview of the planning process. Crucial areas like pricing policies, product mixes and market expansions to name a few are examined in relation to identifying the possible effects of a wide range of strategic decisions of the managers. The simplicity of this method is remarkable given the fact that it can be used in a broad range of context. A managerial analyst can evaluate the effects of decisions that can potentially alter the basic nature of a firm with the use of three inputs of data - sales price, variable cost per unit, and fixed costs. In essence, CVP analysis is a mathematical representation of the economics of producing a product. The financial implications of strategic and operational decisions are evaluated with the use of the CVP model illustrating the relationships between a product's revenue and cost functions. As a quantitative model, CVP can be used in two ways in developing the bulk of relevant financial information for evaluating resource allocation decisions. First, as to measure the sensitivity of a product's profitability to parameter variations and second, it to determine the trade-offs in profitability and risk from alternative product design and production possibilities.

The widespread application of CVP analysis is often criticized because of its use of simplifying assumptions like deterministic and linear cost and revenue functions, Kee (2007) added. These criticisms arise from the method's departure from the standard supply and demand models in price theory economics. Between the two approaches, the most basic difference would be that CVP ignores the curvilinear nature of total revenue and total cost schedules under the assumption that changes in volume have no effect on elasticity of demand or on the efficiency of production factors (Guidry et al, 1998). In addition, the CVP analysis is focused on a single product and single period for analysis that limits its application to businesses producing multiple products and services. This assumption is somehow supported by Guidry, et al. (1998) as a radical departure from the basic simplicity of CVP analysis as a whole if applied to non-linear and stochastic CVP models involving multistage, multi-product, multivariate, or multi-period frameworks although possible. Kee (2007) also cited Horngren, et al. (2000) that the use of the simple CVP model has proven to be helpful to businesses across a variety of industries in both strategic and long-term planning decisions. This comes with a precaution that there can be situations where more sophisticated approaches to financial analysis are required especially when the simple assumption of the CVP analysis cannot appropriately represent revenue and cost. These critiques are recognized by managerial accountants yet their belief on the usefulness of the CVP analysis in the initial stage of strategic decision-making remains untouched.

The treatment of the cost of capital is frequently overlooked in evaluating the use of CVP analysis. Like any other managerial accounting techniques and methods, CVP analysis uses accounting profitability as the primary decision criterion for evaluating resource allocation decisions and ignores the cost of capital and treats it as if it were zero. Failure to incorporate the cost of capital into a product's cost function can lead to underestimating a product's cost while overstating its profitability since the opportunity cost of the funds invested in the assets used to manufacture a product is a cost the same as the cost of operating resources, such as direct material, labor, and overhead (Kee, 2007). He also added that for products requiring a significant investment of capital, ignoring the opportunity cost of invested funds may lead to accepting products whose rate of return is less than the firm's cost of capital. Rather than create products the use of traditional CVP analysis prompts managers to select products that destroy the economic value to the business. Using this analysis also creates bias in using capital in relation to operating resources since the cost of capital is not reflected in the product cost like those of operational resources. This assumption in turn will require additional effort form product designers and developers to use investment funds beyond the point where the marginal benefit of the last dollar of capital used is equal to its marginal cost (Kee, 2007).

Shim & Constas (1997) explains that in nonprofit businesses, financial planning is also required in their operations. Nonprofit managers are also tasked to prepare planning analyses by using cost-volume-revenue (CVR) analysis together with cost behavior information. The analysis deals with how revenue and costs vary with service level change, looking at the effects on revenues of changes in certain factors. These factors include variable costs, fixed costs and service level and by studying the relationships of costs, service volume, and revenue, management is better able to cope with many planning decisions. An integral part of CVR analysis is the break-even analysis that determines the break-even service level though the financial crossover point when revenues exactly match with the costs do not show up in financial reports. Nonprofit managers find break-even point a useful measurement since it reveals which programs are self-supporting and which are subsidized. With this in mind, CVR analysis tries to answer the following questions:

What service level or units of service are required to break even?

How do changes in price per unit, variable costs, fixed costs, and service volume affect surplus?

How do changes in program levels and mix affect aggregate surplus or deficit?

What are some of the break-even strategies available?

Conclusion

Assuming a person decides to put up a business and the capital he needs presents profit opportunities for him, it does not require complicated analysis to conclude that the entrepreneur will have to consider the rate of return of his business as well as alternative business opportunities in other enterprises. The risk involve in investing is evaluated to ensure that the marginal net return from the investment will exceed the net return available in alternative investment opportunities. The differences in risk are taken into account by the investor to protect his interests. This scenario is common among big businesses but for small businesses, this presents a difficulty. Small businesses do not have adequate funds for the opportunities which they believe exist for expansion. They seek funds from other sources in order to facilitate the expansion they are planning for. When a firm borrows money, it should relate the cost of the funds to the net income before income taxes that is provided by the additional investment. If the interest rate is compared with the average profit rate prevailing before the expansion, the expansion may appear desirable. The prudent businessman, however, will estimate the additional (marginal) profit and compare it with the interest cost. The small firm seeking funds for expansion finds that lenders frequently seem more concerned about the repayment program than the rate of interest (Doyle, 1952, pp. 312-313).

Small and large businesses depend their profitability analysis on the forecasts derived from calculating the difference between costs and revenue. This simple yet important approach requires the use of the break-even analysis as a practical and powerful tool. This tool gives light in how to attain desirable alternatives quantitatively focusing on the interrelationship between price and cost. Its basic limitation is its linear nature thus requiring all factors to be carefully defined. To note, long-term costs are variable while short run costs are fixed.

The break-even analysis in essence needs to be used in addition to existing financial methods in line with the business objective to attain the optimum level of business operations. Be it a profit or non-profit business, it is clear that this method is proven helpful and essential to achieve profitable success of a business. Guidry, et al. (1998) relates that widespread historic use of the basic version of the CVP model suggests that a simple, parsimonious analysis is indeed an effective first step in thinking about strategic decisions.

These strategic decisions apply to both small and big businesses and in order to be successful, business owners must first establish their goals, develop a business plan and invest the time and resources for the business to progress. The use of break-even point analysis is also applicable to cash flow management as businesses with low overhead are likely to succeed especially on managing cash flows relating to expenses. The investment would need to include employing an accountant to help them with the analysis and projections that will give them a heads up on what to do and how to attain the goals set for their businesses. Thompson (1993) concludes that making business decisions on gut instinct alone makes margins for error narrow. Basic business analysis is an important step of testing the profitability of any idea, be it additional staff hiring or an introduction of a new product line. The absence of a business plan or its periodic review is a grave mistake that will likely lead to a nightmare that business owners are avoiding.

Many assumptions arise from the arbitrary definitions of variable costs (VC) and fixed costs (FC). With the incremental changes in volume, it lowers the unit fixed cost at one point and the only time it will rise is when added capacity is needed. In order to derive VC and FC, time frames must be assumed with the volume within the relevant range. Aside from these elements, budgets and product costing standards and expense control used may require modification to be applied as each analysis requires individual attention with fully expressed assumptions considered (Lewis, 1986, p. 51).

Thompson (1993) presented this question: "If break-even projections can help pump out more profits, then why don't more entrepreneurs do it?" In the real world, especially with small businesses, the necessity of keeping an accountant on retainer does not look a profitable investment to them, let alone using standard accounting practices. Small business owners are more known to keep all the applicable receipts and financial data in conventional shoeboxes. Most of them do not entertain the idea of employing easy to use computer and manual accounting systems because it would mean additional cost for them and going out of their comfort zone. The profitability of the business lies on the careful maintenance of balance sheets that will show how much the business is earning or losing during its run. One of the basic accounting practices that small business owners can use is the break-even analysis which is not something created out of the blue. This method has been in existence for more than 25 years and accountants have been using it up to present. It works best for single product or service business but for multiservice or product line, modifications on the method is required. It is unfortunate to see that most small business owners fail to keep tabs on their business by preparing financial reports stereotyped as needed only for tax purposes and assessing profits and losses. These business owners do not realize the importance of these reports to monitor the fiscal health of the company. They need accountants to advise them the importance of understanding the significance of recognizing and reaching break-even point in the financial cycle as well as what it takes to break-even to make the business more profitable (Thompson, 1993).

It is important to understand that although the break-even analysis is a tried and test analytical tool, it is not a demand predictor. The success of the business initial lies on the careful assessment on the correct type of service or product that the entrepreneur is willing to gamble in the market. In addition to making strategic decisions to break-even, a closer look on the fixed and variable costs will enable the owner to identify the areas where savings can be possible to maximize profit. In every decision made by the management, there are factors that are being considered prior to coming with a decision. These factors may include implications on the success of the business, financial stability and even the tenure of the employees within the organization. The use of break-even analysis may seem to exclude the aspect that will affect the employees, but in the long run, the outcome of the management's decisions that are based on the analysis done in addition to other analytical methods will benefit or undermine the people involved in the whole process that can be in a form of attrition or employee loyalty for the organization.

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