PROJECT VALUATION
Breakeven Analysis

One of the risks of running a business, both from an operational and well as financial standpoint, is the potential failure to sell enough product or service to earn business costs. On the other hand, certain types of cost tend to increase marginal profitability once certain sales levels are achieved.

Costs fall into variable or fixed categories and impact survivability and profitability in different ways. Variable costs, such as wages, cost of raw stock, and utility bills tend to increase in direct proportion to to the increase in sales level. On the other hand, certain operating expenses such as the depreciation on buildings and equipment, and rents and leases, are fixed, and remain the same over a substantial sales range.

As a result, fixed expenses tend to increase the percentage of profitability once they are paid, while the variable expense of wages, for example, accompany every unit of product sold. On the other hand, fixed costs have to be paid or incurred regardless of production levels. As such, while fixed costs tend to increase profitability, they also increase the risk of the survivability of the business. Variable cost, on the other hand, are incurred proportionately to the units sold, and are paid when sales are made. Fixed costs, on the contrary, have to be accumulated from the sales of many units and are not paid until enough units are sold to pay them.

As a result of this business phenomenon, company decision makers have to decide, where possible, on the levels of fixed and variable costs in their business profile and they use an accounting process called breakeven analysis to do this.

The issue is: how many units of sales or dollars of sales volume will one have to make in business to pay all fixed and variable costs? The formula for units of sales is :

Breakeven = fixed cost/( unit sales price - unit variable cost)

If a company had fixed costs of \$100,000 and sold its product for \$50 with variable costs of \$18 per unit, the company would break even at a unit sales level of:

\$100,000/(\$50-\$18) = 3125 units.

We know this because if we sold 3125 units at \$50 our gross sales volume would be \$156,500, from which we would deduct,\$56,250 in variable expense such as wages, leaving \$100,000 to cover the fixed cost.

If on the other hand management was able to partially automate its production department by replacing a worker costing \$20,000, with a machine, shifting the variable cost to fixed cost and reducing variable cost to \$12 per unit, breakeven would then be:

Breakeven = \$120,000/(\$50-\$12) =3158 units

Note the breakeven would now be higher because higher fixed costs would would have to be accumulated. Further note, however, that on every unit above 3158 units, the profit will be \$38 on each unit instead of the \$32 in the prior scenario. Thus we see how fixed cost increases profitability and risk, and how breakeven analysis is an essential financial tool for business managers.

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