4.8. Cost Structures, Break-Even Point Analysis Flashcards
What calculations do we need to help us decide to integrate or not?
- Cost Structures
- Break-Even Point Analysis
Basic thought process
• How much am I currently producing?
– What are the average costs per unit?
• Am I fully utilizing my capacity?
- Can I increase utilization enough to fill the extra demand?
• What would happen to my costs if I
invested in a bigger plant?
- We assume we can get rid of the small factory at face value
Note on labour costs
- If labour can be easily increased/decreased/reallocated across business units, then labour would be a variable direct cost
- often called semi-variable as it does not perfectly vary with output
- often work contracts are regulated and individuals cannot be fired easily => in this case, labour costs are fixed
Things to consider when making an investment
• How reliable is the price?
• How reliable is the demand?
– Is this product a“fad”that will go out of fashion in a fewy ears?
• What interest rate am I getting (we only looked at EBIT)?
• Market dynamics: How would either selling more units
(plant B at 69%) than currently demanded or less units
(plant A at 100%) than demanded affect market prices?
– The former might lead to lower overall prices in the market but might still benefit the firm
– The latter might lead to an increase in market price if no other firm has spare capacity
• How problematic would it be to coordinate a bigger plant/ a new investment?
What do you do if
(forecast of) demand is unreliable?
Evaluate risks of each investment:
– Break-even point
– Operating elasticity
– We do not need demand for these but only costs and price forecasts
Define break even point of production
- The level of output at which total costs = total revenue - neither profit or loss is made
• We want to find Q such that Revenues (R) = Total Costs
• Lets call P the selling price of each unit
• Lets call VCu the variable costs per unit produced
• Let FC be the total fixed cost
Then, P×Q = (VCu×Q) + FC => (P×Q)-(VCu×Q) = FC
Q×(P - VCu) = FC
Qbreak-even = FC / (P – VCu)
• P-VCu is called the “contribution margin”
=> high break even point = risky
Profit point formula
FC + Target Operating Income / (P- VCu)
Concept of operating risk
• The greater the weight of variable cost in total costs, the narrower the gap/”wedge” in the graph
– (We are assuming the slope of the revenue curve is identical in both options)
• Rigid cost structures (lots of fixed costs) have a greater gap
– You might hear that a firm has “high operating leverage”
=> a higher fixed cost to variable cost ratio is riskier – potential for a higher upside and downside
If a firm has very rigid cost structure (high ratio of fixed costs to total costs):
– The firm will not be able to reduce its costs very much if demand falls short
– But the same firm will respond positively to increases in volumes
Operating elasticity
• Operating elasticity can be measured by calculating the relationship between total variable costs and fixed costs at the BEP.
• Operating elasticity: VCu x QBEP/FC
The higher the operating elasticity, the lower the risk.
HOWEVER, Operating risk is not necessarily a bad thing: it amplifies losses (as we move in the area left to
the BEP), but it also amplifies profits (as we move in the area right to the BEP)
What if BEP and elasticity go in opposite directions?
– First,consider how close the BEPs are–if one is only a few units higher than the other but has higher operating elasticity, then it is less risky
– Do you have any insights on the demand forecast?
Notes to remember
- profitability: \+ operating profits, higher -> better \+ roi, higher -> better - risk: \+ QBEP: the higher, the riskier \+ operating elasticity: the higher the lower the risk
Important remark in exams
• ROI is considered the better indicator compared to
profitability.
• When the two go in different directions, consider ROI
as dominant
