Wednesday, May 5, 2010

Breakeven Analysis

This kind of analysis is useful when considering an investment that will enable you to sell something new, or to sell more of something you already make. It tells you how much (or how much more) you need to sell in order to pay for the fixed investment—in other words, at what point you will break even. With that information in hand, you can look at market demand and competitors' market shares to determine whether it's realistic to expect to sell that much.

In more precise terms, the breakeven calculation helps you determine the volume level at which total contribution from a product line or investment equals total fixed costs. But before you can perform the calculation, you need to understand the components that go into it.

Contribution is defined as unit revenue minus variable costs per unit; it's the sum of money available to contribute to paying fixed costs. Fixed costs are items such as insurance, management salaries, rent, product development costs—they're items that stay pretty much the same no matter how many units of a product or service are sold. Variable costs are those expenses that change depending on how many units are produced and sold; examples would include labor, utility costs, and raw materials.

With these concepts, we can understand the calculation:
1. Subtract the variable cost per unit from the selling price—this is the unit contribution.
2. Divide total fixed costs, or the amount of the investment, by the unit contribution.
3. The quotient is the breakeven volume, expressed as the number of units that must be sold in order for all fixed costs to be covered.
Let's look again at that plastic extruder. Suppose each hat rack produced by the extruder sells for $75, and the variable cost per unit is $22.

$ 75 (unit price)
– 22 (variable cost per unit)

$ 53 (unit contribution)
$ 100,000 (total investment required)
÷ 53 (unit contribution)

1,887 hat racks (breakeven volume)

At this point, Amalgamated must decide whether the breakeven volume is achievable: Is it realistic to expect to sell 1,887 additional hat racks, and if so, how quickly? Note that this volume must be incremental: because Amalgamated has been producing this type of hat rack all along, and the extruder simply represents a way to improve the production process, the compensating sales volume must be above and beyond current sales volume.

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