Financial Analysis: A Controller’s Guide, Second Edition

Chapter 9. Breakeven Analysis

There is usually a very narrow band of pricing and costs within which a company operates in order to earn a profit. If it does not charge a minimum price to cover its fixed and variable costs, it will quickly burn through its cash reserves and go out of business. During the early stages of development of a new product, when pricing can be very high, it is difficult not to cover all possible costs, resulting in easy profits. When competition intensifies, however, prices will drop to the point where they only barely cover costs, and profits are thin or nonexistent. When competition reaches this point of intensity, only those companies with a good understanding of their own breakeven points, and those of their competitors, are likely to make the correct pricing and cost decisions to remain competitive.

This section reviews breakeven analysis, which is also known as the cost volume-profit relationship. This is one of the most important concepts in financial analysis, so the following sections go into some detail regarding how the methodology works, what happens to the breakeven point when all possible variables are altered, and how to use it in a variety of analysis situations. Breakeven charts are used liberally in this chapter, beginning with the most elementary examples, and later progressing through a variety of additional variables that reveal how complex this topic can be.

Basic Breakeven Formula

The breakeven formula is an exceedingly simple one. To ...