Breakeven Analysis Simple & Complex

Transcription

1 Professor Ken Homa Georgetown University Strategic Business Analytics SBA Toolkit Breakeven Analysis Simple & Complex Proprietary Material K.E. Homa

2 Overview A method for calibrating the uncertainty associated with a decision Isolates a key unknown variable, usually volume (quantity) and solves for the value which makes the decision a financial toss-up The answer is then evaluated for likelihood of occurrence, e.g. by comparison to benchmarks & analogies internal and external If the breakeven point is less than likely volume, then the proposal is financially attractive (i.e. better to proceed than not) But, an opportunity projected to be above the breakeven point is not necessarily the best available option since other opportunities may offer even more attractive financial returns only better than doing nothing

3 Typical Applications / Decisions Whether to enter a market or launch a product Whether to increase production or add capacity Whether to increase or decrease price Whether to make a substantial capital outlay

4 Key Financial Variables Revenue = Quantity x Price Profit = Revenue Total Cost Total Cost = Fixed Cost + Variable Cost Variable Cost = f (Quantity) Contribution = Revenue Variable Cost Breakeven Point = Fixed Cost / Contribution (Quantity) (Total) (Per Unit)

5 The basic concept

6 $ Revenue: A function of volume (quantity) and price For simplicity, price is typically assumed to be constant across the relevant range of volume So, revenue curve is portrayed as linear with a slope equal to the constant price VOLUME

7 $ For simplicity, fixed costs are typically assumed to be constant across broad volume ranges Fixed Cost VOLUME

8 $ For simplicity, variable costs are typically assumed to be constant on a per unit basis So, the variable cost curve is linear with slope equal to the variable cost per unit Variable Cost VOLUME

9 $ Total Costs are the sum of fixed and variable costs Variable Cost Fixed Cost VOLUME

10 $ Breakeven Point (BEP):The quantity at which revenue equals total cost BEP Variable Cost Fixed Cost B/E VOLUME

11 $ Breakeven Point (BEP):The quantity at which revenue equals total cost Also, the point at which contribution margin equals fixed costs BEP Contribution Margin = Fixed Cost B/E VOLUME

12 Adding some complexity

13 Fixed Cost Steps For simplicity, fixed costs are typically assumed to be constant across broad volume ranges More realistically, fixed costs are only fixed within a relevant range of output volume (i.e. the quantity of products or services delivered) Said differently, if quantity exceeds current capacity, the next increment of capacity e.g. a new production line, a new factory, a new call center -- typically requires additional fixed costs So, fixed costs often move in capacity chunks that increase fixed costs in non-linear steps

14 $ Fixed Costs often move in capacity chunks that increase fixed costs in non-linear steps Fixed Cost VOLUME

15 $ Even when variable costs are still linear,,, Variable Cost VOLUME

16 $ Total Costs the sum of fixed and variable move in steps Variable Cost Fixed Cost VOLUME

17 $ Breakeven Point (BEP) is still the quantity at which revenue equals total cost BEP Variable Cost Fixed Cost B/E VOLUME

18 Breakeven Point Since a breakeven point is the quantity at which revenue equals total cost It is possible for a company to lose money at a quantity higher than a breakeven point. For example, if a company is breaking even near its full capacity and higher output requires additional capacity with associated fixed costs, then the breakeven point increases and the company may lose money until the new, higher breakeven point is reached

19 Lose Money $ BEP #1 BEP #2 Variable Cost Fixed Cost B/E VOLUME

20 Adding more complexity

21 Hybrid Costs Some costs are neither strictly fixed nor strictly variable. They are often referred to as semi-fixed or semi-variable costs or, more generically, as hybrid costs Example: Some costs may vary as a function of something other than quantity (volume), e.g. the number of customers being served (regardless of their associated volume-based revenue) Example: Some costs may change from fixed to variable, or vice versa e.g. a full-time worker may be a fixed cost for 40 hours of work but be a variable cost when paid extra for overtime at a premium overtime rate or, a consultant may be paid based on an hourly billing rate subject to an overall budget cap that can not be exceeded. Hybrid costs transform breakeven analysis from 2-dimensional checkers to 3-D chess a challenge to show graphically or to model statistically.

22 Still more complexity

23 Revenues Revenue is a function of volume (quantity) and price For simplicity, price is typically assumed to be constant across the relevant range of volume So, a revenue curve is usually treated as linear with a slope equal to the constant price But, keep in mind: Price often decreases as volume increases As volume increases, companies accrue scale economies (based on period volume) and learning curve economies (based on cumulative volume) Market forces and competition tend to push prices down as costs decline though, the full cost drop is not necessarily passed through to customers

24 Variable Costs For simplicity, variable costs are typically assumed to be constant on a per unit basis But keep in mind: Variable costs may decrease as volume increases due to scale & learning curve efficiencies, or may increase at some point due to structural effects or scale inefficiencies For example: Higher volumes may require premium overtime, the use of less efficient labor, or more expensive secondary supply sources

25 Profitability Except for not-for-profits with compelling non-financial objectives, merely breaking even is usually not a satisfactory financial objective So, profit objectives can / should be incorporated into the analysis by Estimating the incremental investment required, applying the company s target ROI, and then treating the profit objective as a addition to fixed costs Or, by adding a required per unit margin to variable cost Note: Either way, the breakeven point increases

26 Key Takeaways

27 Breakeven Point Key Takeaways Breakeven Analysis is a useful technique, especially when revenue (demand) forecasts are highly uncertain Cost modeling is pivotal to breakeven analysis.. i.e. it s critical to pin down the magnitude, structure and dynamics of relevant costs and properly incorporate them into financial models. Fixed? Fixed Steps? Hybrid: Fixed & Variable? Variable? Cost drivers? Shape of the cost functions? How to model? Breakeven analysis calibrates uncertainty and enhances understanding of situational economics,, but it s not a substitute for decision-making