Break-even analysis or CVP analysis

What is it?

A technique for studying the relationship among fixed costs, variable costs, profits and sales volume.

How does it help financial manager?

Break-even analysis tells the manager how profits will vary when production costs, sales volume and selling price vary.

Break-even Point

Break-even point or break-even quantity is that level of production and sales at which total revenues are exactly equal to total operating costs or where operating profits become zero.

Operating profits= Sales Revenue-Total costs

Or EBIT

Revenues:

Refers to the amount that a firm derives from selling its goods and services.

It is calculated by multiplying the selling price per unit (P) and quantity of units sold (Q).

Sales Revenue= P x Q

Operating Costs also known as production costs can be divided into two categories:-

1.Fixed

2.Variable

Fixed Costs

are those operating expenses that do not vary with the level of production.

Variable Cost

Are those expenses that vary directly with the level of production and sales.

Total Variable costs=variable cost per unit x

quantity produced

TVC=V x Q

Total Operating Costs= Fixed Costs +

Variable Costs

Firms Operating Break-even Point

QUnits = FC

P - VC

Where Q= Sales Quantity in units

P=Selling price per unit

FC=Fixed costs per period

VC=Variable costs per period

Effect on

Operating break-Increase in Variable even point

Fixed Costs Increase

Sale price per unit Decrease

Variable Cost per unit Increase

Leverage

Leverage refers to the use of fixed costs in an attempt to increase or lever-up profitability.

Leverage can further be divided into:

1. Operating Leverage

2. Financial Leverage

Operating Leverage

refers to the extent to which a firm uses fixed costs in its operations.

Thus higher the ratio of fixed costs to operating costs – higher operating leverage of a firm.

Measures the sensitivity of a firm’s operating profit to a change in the firm’s sales is called the degree of operating leverage.

DOL= % change in EBIT

% change in Sale

=Sales revenue - VC or EBIT + FC

Sales revenue - VC - FC EBIT

Degree of Operating Leverage

DOL and Break-even Point How close a firm operates to its break-even point determines how sensitive its operating profits will be to a change in output or sales.

Thus the further the level of output is from the break-even point:-Lower the degree of operating leverageGreater is the absolute value of the firm’s operating profit

How would knowledge of a firm’s DOL be of use to a financial manager?

• The manager can know in advance what impact a potential change in sales would have on operating profits

• The firm can also make changes in its sales policy or cost structure

• firms can avoid to operate under conditions of a high degree of operating leverage

DOL and Business Risk• What is Business risk?

The risk to the firm of being unable to cover its operating costs.

• How does DOL affect Business risk of a firm?

DOL is one component of the overall business risk of the firm. Other factors which affect business risk are variability in sales and production costs.

Financial Leverage

involves the use of fixed cost financing by a firm to magnify the effects of changes in EBIT on the firms EPS.

The two fixed financial costs are:-

1. Interest expense on Debt

2. Preferred stock dividends

Financial leverage is employed in the hope of increasing return to common shareholders.

ABC Co.  COMMON DEBT PREFERRED  STOCK      STOCKEarnings before interest and taxes (EBIT) 2,700,000 2,700,000 2,700,000Interest ─   600,000  ─Earnings before taxes(EBT) 2,700,000 2,100,000 2,700,000Income taxes 1,080,000 840,000 1,080,000Earnings after taxes (EAT) 1,620,000 1,260,000 1,620,000Preferred stock dividends ─   ─   550,000Earnings available to common shareholders 1,620,000 1,260,000 1,070,000   Number of shares common stock outstanding 300,000 200,000 200,000   Earnings per share (EPS) Rs.5.40  Rs.6.30  Rs.5.35

Degree of Financial LeverageMeasures the sensitivity of a a firms earnings per share to a change in the firm’s operating profit is called the degree of financial leverage.

DFL= % change in EPS % change in EBIT

EBIT EBIT – I – PD / (1-t )

DFL and Financial Risk•What is financial risk? The risk to the firm of being unable to cover required financial obligations (such as interest, lease payments, preferred stock dividends)

Similarly the variability in earnings per share that is induced by the use of financial leverage by a firm – in other words DFL and the risk of insolvency are both part of financial risk.

Total Leverage

When financial leverage is combined with operating leverage , the result is referred to as total (or combined) leverage.

Degree of Total Leverage

a measure of the total sensitivity of a firm’s earnings per share to a change in firm’s sales is called degree of total leverage.

DTL = % change in EPS

% change in sales

Or

DTL = DOL x DFL