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Credit Analysis.  Break even and Leverage

Explains how businesses can adjust costs and levels of production to attain optimum results.

Break even point (BEP) is the level of production at which a firm’s revenues just cover its costs. Beyond this level the firm earns profits; anything below this level leads to losses.

To calculate the break even point we must differentiate between Fixed and Variable Costs. What kind of costs, besides interest, can be included in the category of fixed costs? Administrative or contractual salaries & benefits, insurance, property & business taxes, rentals, leases, etc are all examples of fixed costs. Variable costs usually include direct production expenses (labor, raw materials, overheads), marketing and selling expenses.

Note: At times, an analyst must use his discretion to decide whether a certain cost is fixed or variable in nature. Some expenses have a fixed component as well as a variable component. For example, salespersons’ compensation packages have a basic salary and additional compensation through commissions. One needs to separate the fixed and variable portions accordingly.

Now that we have separated the expenses into their fixed and variable components, we are all set to calculate that level of production at which the firm can operate at breakeven.

Consider the following information, obtained from the Income Statement of Woody & Company. The firm is in the business of making wooden furniture and supplied chairs to customers across North America.

Fixed Costs totaled $ 250,000 in 1999.

Selling Price per unit was $20

Variable Cost per unit was $12

The breakeven level of sales, in units can be calculated as follows:

BEP=    (Fixed Costs) divided by (Selling Price – Variable Cost)

Whenever the variable cost is subtracted from the selling price (a per unit cost or a total amount), the Contribution Margin is obtained.

In this case, the selling price and variable cost is taken per unit. So, the breakeven point is 31,250 units as shown above. The breakeven point can also be obtained in dollars by multiplying Breakeven units by Selling Price per unit.

Break even point in dollars = Unit Break even * Selling Price

In the case of Woody & Company, the break even point in dollars is as follows:

We can now see that lower fixed costs (or higher prices) will lead to a lower break even point, and a business will be able to reach profitability sooner.

Let’s delve deeper into Woody’s situation. Assume that Woody’s management is expecting the same cost and revenue structure in 2000 as it did in 1999. The only difference is that a recent capacity upgrade has now added another 15,000 units of production capacity and 200,000 in fixed costs. How will this affect the profitability of the firm? Would producing at 100% capacity help?

Even if the firm produces 46,250 units at 100% capacity, it will not be profitable. With this fixed cost structure, we need another 10,000 units to hit the break even point at 56,250 units.

What if management believes that even though fixed costs will increase by $200,000, variable costs will reduce by 33% to $8 due to the upgraded technology and capacity? What would be Woody’s break even point in such a scenario?

We see that if variable costs decline by $4 and fixed costs increase by $200,000, Woody would be profitable at the 46,250-unit production level.

Can you see how changes in these cost components have a direct impact on the break even point and profitability of a business?

Margin of Safety

Break even analysis is an important tool in planning, analysis and projecting future earnings. As a manager, you have targets and profit goals. When planning to achieve those profit goals, you have two things to work with: revenues (sales) and costs (fixed and variable costs). The same is true for an investor who has a targeted Return On Investment. For both these individuals a key concern is the cushioning the current level of sales or revenues provide against losses. Up to what level can sales decline before things start getting tight?

In Woody’s case, after all the upgrades and improvements are in place, the break even level of sales for the next year is 37,500 units or $750,000. Woody plans to produce and expects to sell 46,250 units for $925,000. The Margin of Safety in this case is 8,750 units or 175,000 in revenues. The big assumption in this case is that Woody’s production will reflect market demand and that there will be no excess inventory left at the end of year. Translation “Woody will sell everything it produces”.

As an investor you can decide if this Margin of Safety is good enough for you or not. Is the difference between the existing (or desired) sales level and the break even point big enough? If costs remain constant and sales fall, the Margin of Safety also falls, indicating that the business is nearing levels at which either costs will equal or exceed revenues.

Now stop for minute and think about fixed costs again. Which business would you prefer to invest in or manage? One in which the margin of safety is 1,000,000 dollars because fixed costs are low or one in which the margin of safety is 100,000 because fixed costs are high.

Key Takeaway

The larger the magnitude of fixed costs, the higher the volume of sales that is required to break even. Recognize that carrying a high fixed costs load can create problems during down turns, i.e. when sales are low or are not as expected.