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Break-Even Analysis or CVP Analysis: Profits Will Vary When Production Costs, Sales

Break-even analysis is a technique used by financial managers to understand the relationship between fixed costs, variable costs, sales volume, and profits. It determines the sales volume needed to cover total costs. The break-even point is where total revenues equal total costs and operating profits are zero. Financial managers use break-even analysis to understand how changes in costs, prices, and sales impact profits. Leverage refers to the use of fixed costs, which can increase profits but also increases business and financial risk for the firm.

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137 views17 pages

Break-Even Analysis or CVP Analysis: Profits Will Vary When Production Costs, Sales

Break-even analysis is a technique used by financial managers to understand the relationship between fixed costs, variable costs, sales volume, and profits. It determines the sales volume needed to cover total costs. The break-even point is where total revenues equal total costs and operating profits are zero. Financial managers use break-even analysis to understand how changes in costs, prices, and sales impact profits. Leverage refers to the use of fixed costs, which can increase profits but also increases business and financial risk for the firm.

Uploaded by

smurtazarizvi
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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Break-even analysis or CVP

analysis
What is it?
A technique for studying the relationship
among fixed costs, variable costs, profits
and sales volume.

How does it help financial manager?


Break-even analysis tells the manager how
profits will vary when production costs, sales
volume and selling price vary.
Break-even Point
Break-even point or break-even quantity is that
level of production and sales at which total
revenues are exactly equal to total operating
costs or where operating profits become zero.

Operating profits= Sales Revenue-Total costs


Or EBIT
Revenues:
Refers to the amount that a firm derives
from selling its goods and services.

It is calculated by multiplying the selling


price per unit (P) and quantity of units sold
(Q).

Sales Revenue= P x Q
Operating Costs also known as production
costs can be divided into two categories:-
1.Fixed
2.Variable

Fixed Costs
are those operating expenses that do
not vary with the level of production.
Variable Cost
Are those expenses that vary directly with the
level of production and sales.

Total Variable costs=variable cost per unit x


quantity produced
TVC=V x Q

Total Operating Costs= Fixed Costs +


Variable Costs
Firms Operating Break-even Point

QUnits = FC
P - VC

Where Q= Sales Quantity in units


P=Selling price per unit
FC=Fixed costs per period
VC=Variable costs per period
Effect on
Operating break-
Increase in Variable even point

Fixed Costs Increase


Sale price per unit Decrease
Variable Cost per unit Increase
Leverage
Leverage refers to the use of fixed costs in an
attempt to increase or lever-up profitability.

Leverage can further be divided into:


1. Operating Leverage
2. Financial Leverage
Operating Leverage
refers to the extent to which a firm uses
fixed costs in its operations.

Thus operating leverage is present anytime


a firm has fixed operating costs —
regardless of volume.
Degree of Operating Leverage
Measures the sensitivity of a firm’s operating
profit to a change in the firm’s sales is called
the degree of operating leverage.

DOL= % change in EBIT


% change in Sale

=Sales revenue - VC or EBIT + FC


Sales revenue - VC - FC EBIT
How would knowledge of a firm’s DOL
be of use to a financial manager?
• The manager can know in advance what
impact a potential change in sales would
have on operating profits
• The firm can also make changes in its
sales policy or cost structure
• firms can avoid to operate under
conditions of a high degree of operating
leverage
DOL and Business Risk
• What is Business risk?
The risk to the firm of being unable to
cover its operating costs.

• How does DOL affect Business risk of a


firm?
DOL is one component of the overall
business risk of the firm. Other factors
which affect business risk are variability in
sales and production costs.
Financial Leverage
involves the use of fixed cost financing by a
firm to magnify the effects of changes in EBIT
on the firms EPS.

The two fixed financial costs are:-


1. Interest expense on Debt
2. Preferred stock dividends

Financial leverage is employed in the hope of


increasing return to common shareholders.
Degree of Financial Leverage
Measures the sensitivity of a a firms earnings
per share to a change in the firm’s operating
profit is called the degree of financial leverage.

DFL= % change in EPS


% change in EBIT
EBIT
EBIT – I – PD / (1-t )
DFL and Financial Risk
• What is financial risk?
The risk to the firm of being unable to cover
required financial obligations (such as
interest, lease payments, preferred stock
dividends)

Similarly the variability in earnings per


share that is induced by the use of financial
leverage by a firm – in other words DFL
and the risk of insolvency are both part of
financial risk.
Total Leverage
When financial leverage is combined with
operating leverage , the result is referred to
as total (or combined) leverage.

Degree of Total Leverage


a measure of the total sensitivity of a firm’s
earnings per share to a change in firm’s
sales is called degree of total leverage.
DTL = % change in EPS
% change in sales

Or

DTL = DOL x DFL

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