Break-even analysis

Before a company decides to embark on a particular project break-even analysis will be carried out to predict the point below which it will cease to make a gross profit on sales—its break-even point.

The difference between a projected level of sales and break-even point is known as the margin of safety. It represents how much sales can fall short of the target before a loss is made. It therefore gives an indication of how much the project could withstand adverse trading conditions. Margin of safety can be expressed either as a percentage of sales or as units of product sold.

To construct a break-even chart step by step

Add up all the costs that you’ll incur even if you don’t sell any of your products or services, e.g. rent, administrative wages, etc. These are your fixed costs. Draw an x (horizontal) and a y (vertical) axis to meet each other at the bottom left hand corner. Label this point 0 (zero), because it represents no unit sales and no costs or revenues. Calibrate the x axis in whatever units of hypothetical sales seems appropriate, i.e. plot marks on the line representing hundreds, thousands, or any other scale of unit sales that seems appropriate.

Calibrate the y axis with monetary levels, i.e. mark it off in units of hundreds or thousands of pounds sterling, or whatever other scale you regard as appropriate.

Plot the total fixed costs on the y axis and draw a horizontal line. Label this ‘Fixed costs’.

Next, add up all the costs that can be directly attributed to a single unit, or particular quantity of units sold, e.g. saleperson’s commission, purchases and cost of production. Plot this figure multiplied by each quantity marked on the x axis vertically above that quantity and horizontally against the appropriate height on the y axis, after first adding the fixed cost value (which is the same regardless of how many are sold). In other words, start counting up the y axis, not from zero, but from the level at which fixed costs are plotted. Draw a line through the plotting. The line will be sloping and will meet the y axis at the point where the fixed costs line starts. Next plot the revenues for each volume of sales in the same way, except that here you start from the zero level. See Figure 124 for an example.

The principle advantage of break-even analysis is that because the break-even point is presented graphically.

• The information is externalised so that it can be communicated and shared.
• The project can be handled more objectively.

There are some disadvantages, though

• Costs many not be linear, or only linear within a particular range. In fact economies and diseconomies of scale will, to some degree, prevent costs and revenues being linear.
• It is sometimes difficult to distinguish between fixed and variable costs.
• The use of break-even analysis assumes a single product. Most companies have a mixture of products and services for sale, so you would either need several break-even charts, or plot sales in purely monetary units, rather than units of any particular product. Then it may be difficult to accurately plot direct costs since there may be different direct costs for each sales product.

Cash flow projection

No matter how much profit a firm is making it can still run out of cash. This can happen if, for example, it allows its customers eight weeks to pay their debts while it pays its own in four, or if it channels a lot of its sales revenues into purchasing fixed assets, leaving insufficient amounts to pay its trade creditors on time. If this happens the company may miss out on early settlement discounts or, worse still, suppliers might withdraw credit terms. Other cash commitments may be affected too—for example, the firm may be unable to pay wages on time. To avoid this happening a cash flow projection is drawn up, comparing planned inflows and outflows month by month over the period of the trading year.

Compiling a cash flow projection step by step

Prepare a table with 13 columns and 11 rows. Use the first column to label the meaning of the values in each row and the first row to label the months 1-12 in the trading year. This will leave 12 columns and 10 rows for data. These will, from here on, be referred to as columns 1-12 and rows 1-10 respectively. The first 3 labels down the left hand side are income categories: Sales revenue, Income from other sources and Total income. The next 4 (rows 4-7 inclusive) are outgoings: Purchases, Overheads, Other outgoings and Total outgoings. The next row (row 8) is for Net income/outgoings, i.e. the surplus of one or the other. Row 9 is for Opening bank balance (predicted at start of that month). The final row is for Closing bank balance calculated for that month, which will be the sum of rows 8 and 9.

Then you plot the figures you calculate it will be reasonable to expect. Sum rows 1 and 2 and put the answers in the total boxes in row 3. Sum rows 4-6 and enter the answers in the total boxes in row 7. Deduct row 7 from row 3 and put the differences in the answer boxes in row 8. Sum rows 8 and 9 and put the answers in the total boxes in row 10. Figure 125 is an example.

This is a general guide. In particular situations there may be more income and

Investment appraisal

Before assessing what there is to gain by investing in a project a firm needs to take the opportunity cost into account. That is the return it could expect if it placed its funds in a safe investment, like a building society account, or UK treasury bonds instead. The difference is what there is to gain from taking the risk. However, entrepreneurs need to make some other checks too. Here are four well-used strategies for investment appraisal.

• Pay back period.
• Average rate of return (ARR).
• Internal rate of return (IRR).
• Net present value.

Pay back period

The pay back period is the first test that is usually made. It tells you how long it will take to get your money back if things go to plan. This, in turn, says something about the risk, for the further into the future we have to extend our exposure to risk the more uncertain things become. It is often used as an initial screening strategy for investment proposals using a set maximum payback period above which rejection is automatic.

Average rate of return

The average rate of return is a measure of the average annual profit the firm will receive from the averaged out value the assets in the project will have over the project’s lifespan. The latter is found by deducting projected residual value from initial cost to allow for depreciation. However, many firms often dispense with this deduction and just keep the assets figure at cost. This is not a bad idea, since that more accurately reflects their investment than does a depreciated figure. This, too, is often used as a screening method with a set minimum ARR below which rejection is automatic.

The weakness of this method is that it assumes that returns will not vary across the years. This might not be the case. The highest returns might not come until the later years. If an average rate of return of 30% annually actually reflects 10% in year 1, 20% in year 2 and 60% in year 3 (which still produces an average of 30% annually) then only a small portion of the total return will earn interest in the bank over the long period, but the large proportion of it will earn little or none, since it will not be earned until year 3.

It would be quite the reverse if the 60% return was expected in the first year and the 10% in the last year.

Internal rate of return

A method that takes this into account is the internal rate of return method. This converts the expected returns to compound interest equivalents.

The internal rate of return method considers that rate of discount which when applied to the returns of the proposed investment would result in a zero level net present value, (i.e. the reverse of compound interest which starts with no interest and ends with the accumulated returns). This percentage is often used as an accept or reject screening process with a minimum rate of discount being required (say, for example 18%) to avoid automatic rejection.

To find the projected internal rate of return on a project, list and sum the expected annual returns over the projected lifespan of the investment. Deduct the initial investment figure and divide the difference by the number of years. Then divide that figure by half of the initial investment figure and multiply by 100 to give an approximation to begin a trial and error process towards finding the internal rate of return.

Using a discount table select the column which most closely matches the approximation and select the figures by which to multiply each year’s return to find the discounted return for that year. Then sum the products for all the years and check how close it is to the initial investment. If it is substantially more then reduce the approximation and try again, if substantially less then increase the approximation. Keep doing this until the sum of the products is more or less equal to your initial investment figure (say within 0.1%). The discounted rate of return (column heading) you last used is the internal rate of return the investment can be expected to produce.

Investing in company shares

Before investing in a company’s shares investors compare their value with that of other similar companies and with various yardsticks. Here are the three most basic and commonly used key ratios.

A fall in earnings per share many not in itself be sufficient reason to avoid investment, as it may mean the company has simply kept more on general reserve. However, in reality any announcements that suggest reductions on distributed profits usually have a negative effect on demand for shares, sending

prices lower.

Price/earnings ratio is commonly used as a measure of value in investment decisions. Different sectors of the stock market have different average price/ earnings ratios, reflecting the different levels of risk. Both the level of risk and a share’s PER is compared with others in the sector.

Overhead absorption

A product’s contribution to overheads is the net sales revenue from that product less the direct costs of production (materials and labour). See Figure 127.

Overhead apportionment refers to dividing the total overhead costs in a production run by the number of units produced but this is done in a weighted way. For example if the production of Produce A uses a machine twice as much as Product B then the overhead cost of that machine will be apportioned to Products A and B in the ratio of 2:1. Similarly, if the production of Product B requires 30% more factory space than Product A then the factory overhead will be apportioned to A and B in the ratio 1:1.3.

Often overheads are apportioned to cost centres and products then absorb them in the same proportions as they use those cost centres’ time.

As long as you know:

• the total costs of each type of overhead
• the criteria for apportionment
• the criterion values for each cost centre

the rest is just a matter of simple ratio analysis. Figure 127 gives an example.