Breakeven Point: Understanding and Calculating | CFA Level I Corporate Issuers
Welcome back as we learn what is a breakeven point for a firm, and how to calculate it.
What is the Breakeven Point?
Thus far, we have learnt that the cost structure of a firm consists of fixed financing costs, fixed operating costs, and variable costs.
If we plot a firm’s total costs against the number of units it produced and sold, we get this upward sloping straight line where the steepness is determined by the variable cost per unit. The higher the variable cost, the steeper is this line.
The breakeven point is the number of units a firm needs to produce and sell in order to fully cover all of its variable and fixed costs. So if we plot the revenue against the number of units sold, the intersection between the two lines is the breakeven point where revenue equals total cost.
Contribution Margin and Breakeven Point
The contribution margin is the difference between the price and variable cost per unit.
Contribution margin = Price – Variable cost(per unit)
When the contribution margin widens, the breakeven quantity is reduced. Conversely, when it narrows, the breakeven quantity increases. And if the sales price per unit cannot even cover the variable cost, the breakeven quantity is infinite, and the company should probably… ahem … fold up.
Calculating the Breakeven Point
Calculating this breakeven point is simple. Revenue is the quantity of sales multiplied by the price per unit. Total cost is the quantity of sales times the variable cost per unit, plus the fixed operating costs, plus the fixed financing costs. Solve for the quantity where revenue equals the total cost, and we get this equation:
Breakeven Quantity = (Fixed Operating Costs + Fixed Financing Costs) / (Price per Unit – Variable Cost per Unit)
Let us first recall the formula for breakeven quantity. We know the fixed operating costs, the fixed financing costs, and the price per unit, so the only thing we need to calculate is the variable cost per unit.
Plug all the figures into the formula, and we get a breakeven quantity of 7,500 units.
Operating Breakeven Point
Sometimes, you may need to exclude financing cost in order to make better comparisons across companies with different capital structures.
This is known as the operating breakeven point, which is simply the fixed operating cost divided by the contribution margin per unit. This is the point where the revenue is equal to the total variable cost, plus only the fixed operating costs.
Operating Breakeven Quantity = Fixed Operating Costs / (Price per Unit – Variable Cost per Unit)
So, back to our last example, if we want to calculate the operating breakeven point for Adodos Corp, we exclude the fixed financing costs and get an answer of 4,500 units.
And that concludes this topic on the measures of leverage. This is one of the easier parts of the exam, so make sure you are able to recall the formulas correctly and score in the exam.