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Break Even Analysis

Lecture 5 This lecture is part of Chapter 2: Budgets, Running a Company

Todays Lecture
Fixed versus Variable Costs Break Even Analysis Learn how to use the Solver in Excel

Break-Even Analysis
An important part of running a company is the determination of how the company should be financed and how the prices of the products the company sells should be set. Clearly, in order to do this properly a sound financial analysis is necessary.

Types of costs
It is essential to realize that there are two basic types of costs a company incurs. Variable Costs Fixed Costs Variable costs are roughly proportional to a companys sales. I.e. the cost per unit remains roughly constant. Fixed costs remain roughly the same regardless of sales. I.e. the cost per unit is inversely proportional to sales.

Types of costs
Sales Value Total Costs Variable Costs Fixed Costs

Sales A simple graph but important to understand!

Break-Even Analysis
Commonly, the Break-even point is defined to be the level of sales where:

Revenues = Expenses
Let us have a look at a simple example. Aunt Petunia opens a flower shop.

Break-Even Analysis
Fixed Costs: Rent: 5,000 Utilities: 300 Helper: 1,500

Variable Costs: Flowers: 40% of selling price

So we know that: Selling price cost of flowers rent utilities helper = 0 when she breaks even

Break Even Analysis


Lets enter the last line into the spread sheet
A 2 3 4 5 6 7 8 9 10 11 12 B C D E F G H I Auntie Petunia Flowers - Break even Analysis

Sales Cost of Sales Rent Utilities Helper Net Income

0 5000 300 1500 -6800

Cost as percentage of sales 40%

But!!!?? Im not a Mathematician! How am I going to find the value for E6 so that E11 = 0?

=E6-E7-E8-E9-E10

=E6*$H$7

We learned something in the last lesson. Its good to put the assumptions separately.

Break Even Analysis


Piece of cake! Trial and error!
A 2 3 4 5 6 7 8 9 10 11 12 B C D E F G H I Auntie Petunia Flowers - Break even Analysis

Sales Cost of Sales Rent Utilities Helper Net Income

12600 5040 5000 300 1500 760

Cost as percentage of sales 40%

Oops! Not as easy as I thought. Especially if H7 is not a nice number like 40%.

Is there a better way?

The Solver
We could cave and write down the equation. That would, in fact not be such a bad idea since equations are really not as difficult to understand when one knows what they are supposed to mean. But *** RELIEF *** Excel has an incredibly useful function called the solver. It will solve equations without giving it the equations! That was close .

The Solver
The Solver can be found in the Tools menu of Excel. If its not there, it can be installed by going to the Addins menu item and selecting the Solver Add-in.

This is really quite selfexplanatory! Enter the appropriate values for Set target cell, Equal to and By changing cells, and click Solve.

Break Even Analysis


Let try out the Solver!
A 2 3 4 5 6 7 8 9 10 11 12 B C D E F G H I Auntie Petunia Flowers - Break even Analysis

Sales Cost of Sales Rent Utilities Helper Net Income

11,333 4,533 5,000 300 1,500 0

Cost as percentage of sales 40%

Incredible! Like this anyone can do Math!

The break even point is 11,333

An Equation
The Solver is a fabulous tool, but really in business it is beneficial to at least be open-minded about equations. Lets give it a try! We know that: E11=E6-E7-E8-E9-E10 (Income = Sales Cost Rent Utilities Helper) At the break even point, Net Income = 0 and hence E11 =0 Inserting this we obtain: 0 = E6-E7-E8-E9-E10

An Equation
We want to change E6 such that 0 = E6-E7-E8-E9-E10 is true. Ah, if we just set E6 to the other values together the above equation is true. Or, E6 = E7+E8+E9+E10 is the solution to our problem. Lets try it and go back to the situation before we used the solver:

Break Even Analysis


Lets fill the equation into cell E6
A 2 3 4 5 6 7 8 9 10 11 12 B C D E F G H I Auntie Petunia Flowers - Break even Analysis

Sales Cost of Sales Rent Utilities Helper Net Income

0 0 5000 300 1500 -6800

Cost as percentage of sales 40%

Oops!

=E7+E8+E9+E10

What went wrong?

An Equation
May be Math isnt as easy as I thought But wait, doesnt E7 depend on E6? Yes indeed, we have defined E7 = E6 * H7 (cost of product). Lets put this into our equation: E6 = E7+E8+E9+E10 => E6 = E6*H7+E8+E9+E10 Or: E6 - E6*H7 = E8+E9+E10 E6 * (1 - H7) = E8+E9+E10 E6 = (E8+E9+E10) / (1 - H7)

Break Even Analysis


Yosh! Lets try that again.
A 2 3 4 5 6 7 8 9 10 11 12 B C D E F G H I Auntie Petunia Flowers - Break even Analysis

Sales Cost of Sales Rent Utilities Helper Net Income

11,333 4,533 5,000 300 1,500 0

Cost as percentage of sales 40%

Yatta! It works

(E8+E9+E10) / (1 - H7) After all, this was quite easy wasnt it? And now we can change H7 to play out scenarios. Very useful indeed!

Break Even Analysis


If Aunt Petunia raises the price so that the cost is only 30% of sales .
A 2 3 4 5 6 7 8 9 10 11 12 B C D E F G H I Auntie Petunia Flowers - Break even Analysis

Sales Cost of Sales Rent Utilities Helper Net Income

9,714 2,914 5,000 300 1,500 0

Cost as percentage of sales 30%

she can break even already at 9714. Of course now she may be so expensive that no one wants to buy her flowers anymore.

The other way around


There may be times when it is better to turn things around. Just now, Aunt Petunia found how much she needs to sell in order to break even given certain cost as percentage of sales. This is in general a good idea since for many products the profits are more or less set. In order to see how feasible a business is one could also enter an expected sales amount and then see how much the cost of the product can be in order to break even.

Break Even Analysis


With our nice equation, its fairly easy to accomplish this: E6 * (1 - H7) = E8+E9+E10 (1 H7) = (E8+E9+E10)/E6 H7 = 1 - (E8+E9+E10)/E6
A 2 3 4 5 6 7 8 9 10 11 12 B C D E F G H

Cool! And I thought that Financial Analysis is only for others


I

Auntie Petunia Flowers - Break even Analysis

Sales Cost of Sales Rent Utilities Helper Net Income

12,000 5,200 5,000 300 1,500 0

Cost as percentage of sales 43%

Key Points of the Day


The Solver is a great tool But Math can be very useful as well There are two types of costs: Variable Costs Fixed Costs Break Even Analysis is a snap with Excel