Break-Even Analysis

Breakeven is the number of units that need to be sold to cover all of the expenses. Compared to the other capital investment calculations, the break-even formula is relatively simple. For manufacturing calculations, the sales price per unit is the sales price. For capital investment analysis, the sales price per unit is the increase in revenue from the new venture or the associated savings. Vision Inc. is considering purchasing a machine for $500,000 to make a new product. The labor cost is $12 per hour, and each unit takes four hours to produce. The materials cost $7 per unit. Each unit of the new product will sell for $100. The variable costs are the direct costs associated with making one unit. In this case, 4 hours of labor at $12 per hour is added to materials of $7 per unit. Using this information, the breakeven for the units made is calculated, showing how many units need to be manufactured to cover manufacturing expenses. The break-even sales is the dollar amount that correspond to the units being sold, and the break-even point is the point in time when this happens. Break-even units can be calculated. At $100 per unit, the break-even sales are $1,111,100. If the new machine can produce 500 units per month, the break-even point for this investment can be calculated. This is the point in time when the investment begins to pay off by generating positive cash flow. Graphically, breakeven is the intersection of the total costs line and the total income line. Marginal costs (MC), average total costs (ATC), and average variable costs (AVC) are all associated with the production process. Marginal costs of production include all of the costs that vary with the level of production. Average total costs are unit costs that include all fixed costs and all variable costs. Knowing the average total cost is critical in making pricing decisions, as any price below average total cost will result in a financial loss. Finally, average variable costs represent the total variable cost per unit, including materials and labor, in short-term production calculated by dividing total variable costs by total output. A shutdown point is a level of operations at which a company experiences no benefit for continuing operations and therefore decides to shut down temporarily, or in some cases, permanently. It results from the combination of output and price where the company earns just enough revenue to cover its total variable costs. The shutdown point denotes the exact moment when a company's marginal revenue is equal to its variable marginal costs. In other words, it occurs when the marginal profit becomes negative. Breakeven analysis can be used in conjunction with discounted cash flow to give an accurate representation of actual cash flow. Both discounted cash flow, a system of calculating the present value of forecasted future cash flows, and internal rate of return, the measure of an investment's rate of return, assume that the income will be reinvested. This is true up to the break-even date. After that date, the cash flow may be invested in other projects, as it is profit after that time. These other investments may have different return rates and cash flows, leading to a new or more robust capital structure analysis.