Operating breakeven analysis is a method of determining the point at which sales will just

cover operating costs—that is, the point at which the firm’s operations will break even.

It also shows the magnitude of the firm’s operating profits or losses if sales exceed or fall
below that point.
Breakeven analysis is important in the planning and control process because the cost-
volume-profit relationship can be influenced greatly by the proportion of the firm’s
investment in assets that are fixed.

Sufficient volume of sales must be anticipated & achieved if fixed & var costs are to be
covered, or else the firm will incur losses from ops. In other words, if a firm is to avoid
accounting losses, its sales must cover all costs

Costs that vary directly with the level of production generally include the labor and
materials needed to produce and sell the product, whereas the fixed operating costs
generally include costs such as depreciation, rent, and insurance expenses that are incurred
regardless of the firm’s production level.
Operating breakeven analysis deals only with the upper portion of the income
statement—the portion from sales to net operating income (NOI), also termed EBIT. This
is referred as the operating section because it contains only the revenues & expenses
associated with the normal production and selling operations of the firm.

As per the information in the table, Unilate has fixed costs, which include depreciation, rent,
insurance, etc., equal to $154 M. This amount must be paid even if the firm produces & sells
nothing, so the $154 M fixed cost is depicted by a horizontal line.

If Unilate produces & sells nothing, its sales revenues will be zero; but for each unit sold, the
firm’s sales will increase by $15. Therefore, the total revenue line starts at the origin of the x
and y axes, and it has a slope equal to $15 to account for the dollar increase in sales for each
additional unit sold.
The line that represents the total operating costs intersects the y axis at $154 M, which
represents the fixed costs incurred even when no products are sold & it has a slope equal to
$12.30, which is the cost directly associated with the production of each additional unit sold

The point at which the total revenue line intersects the total operating cost line is the
operating breakeven point (QOpBE and SOpBE) because this is where the revenues
generated from sales just cover the total operating costs of the firm.
 Operating Breakeven Graph

SOpBE = operating breakeven in dollars

Q = sales in units: QOpBE = operating breakeven in units
F = fixed costs = $154 million
V = variable costs per unit = $12.30
P = price per unit = $15.00

Contribution Margin - Contribution margin (CM), or dollar contribution per unit, is the
selling price per unit minus the variable cost per unit. "Contribution" represents the
portion of sales revenue that is not consumed by variable costs and so contributes to the
coverage of fixed costs.

For Unilate, it is $2.70, which is the difference between the $15 selling price and the
$12.30 variable cost of each unit.

Operating Breakeven Computation

From the above equation we can see that the operating breakeven point is lower (higher)
if the numerator is lower (higher) or if the denominator is higher (lower).
Therefore, all else equal, one firm will have a lower operating breakeven point than
another firm if its fixed costs are lower, if the selling price of its product is higher, if its
variable operating cost per unit is lower, or if some combination of these exists.
Operating breakeven point in terms of sales revenues
The operating breakeven point also can be stated in terms of the total sales revenues
needed to cover total operating costs.
At this point, we simply need to multiply the sales price per unit by the breakeven quantity
we found using the above equation, which yields $855.6 million (57.04 x $15.00) for Unilate.
Alternatively, we can restate the contribution margin as a percent of the sales price per unit
(this is called the gross profit margin) and then apply the above equation. In other words,

This computation shows that $0.18 of every $1 in sales revenue goes to cover the fixed
operating costs, so about $856 million worth of the product must be sold to break even.

Operating breakeven analysis can shed light on three important types of business decisions:
1. When making new product decisions, breakeven analysis can help determine how
large the sales of a new product must be for the firm to achieve profitability.
2. Breakeven analysis can be used to study the effects of a general expansion in the
level of the firm’s operations; an expansion would cause the levels of both fixed and
variable costs to rise, but it would also increase expected sales.
3. When considering modernization projects, in which the fixed investment in
equipment is increased to lower variable costs, particularly the cost of labor,
breakeven analysis can help management analyze the consequences of purchasing
these projects.

OPERATING LEVERAGE
If a high percentage of a firm’s total operating costs are fixed, the firm is said to have a high
degree of operating leverage.
In business terminology, a high degree of operating leverage means that a relatively small
change in sales will result in a large change in operating income.
Operating leverage arises because the firm has fixed operating costs that must be covered
no matter the level of production. Impact of leverage, however, depends on the actual
operating level of the firm.

To measure the effect of a change in sales volume on NOI, we calculate the degree of
operating leverage, which is defined as the percentage change in NOI (or EBIT) associated
with a given percentage change in sales:
Table in slide # 6 shows that NOI for Unilate is $143.0 M at production and sales equal to
110 M units. If the number of units produced and sold increases to 121 M (a 10% increase),
the operating income (in millions of dollars) would be

So the degree of operating leverage associated with this change is:

Taken literally then, Unilate’s DOL of 2.08 indicates that the percent change in operating
income will be 2.08 times the percent change in sales from the current 110 M units
($1,650.0 M).
If the number of units sold increases by 10%, to 121 M, Unilate’s operating income should
increase by 2.08 x 10% = 20.8%.

The above equation can be simplified so that the degree of operating leverage at a
particular level of operations can be calculated as:

Rearranging the terms, DOL can be stated in terms of sales revenues:

The DOL of 2.08 indicates that each 1 percent change in sales will result in a 2.08 percent
change in operating income. What would happen if Unilate’s sales decrease, say, by 10
percent? Unilate’s operating income would be expected to decrease by 20.8%.

The DOL value indicates the change (increase or decrease) in operating income resulting
from a change (increase or decrease) in the level of operations.
It should be apparent that the greater the DOL, the greater the impact of a change in
operations on operating income, whether the change is an increase or a decrease.
The DOL value found by using above equation is the degree of operating leverage only for
a specific initial sales level
When Unilate’s operations are closer to its operating breakeven point of 57.04 M units, its
degree of operating leverage is higher.

Given the same operating cost structure, if a firm’s level of operations is decreased, its
DOL increases.
We can say, the closer a firm is to its operating breakeven point, the greater is its degree
of operating leverage. This occurs because, buffer in operating income is not large to
absorb a decrease in sales & be able to cover the fixed operating costs.

Similarly, at the same level, a firm’s degree of operating leverage will be higher if the
contribution margin for its products is lower. The lower the contribution margin, the less
each product sold is able to help cover the fixed operating costs.
Therefore, higher the DOL for a particular firm, it can be concluded the closer the firm is to
its operating breakeven point or the contribution margin is low.
Greater sensitivity generally implies greater risk; thus, it can be stated that firms with
higher DOLs generally are considered to have riskier operations than firms with lower
DOLs.

Consequently, all else equal, of the three textile manufacturers, Unilate’s operating
income would be magnified the most if actual sales turned out to be greater than
forecasted; but it also would experience the greatest decrease in operating income if
actual sales turned out to be less than expected.

FINANCIAL BREAKEVEN ANALYSIS

Operating breakeven analysis deals with evaluation of production & sales to
determine at what level the firm’s sales revenues will just cover its operating
costs, the point at which the operating income is 0
Financial breakeven analysis is determines the NOI or EBIT, the firm needs to
just cover all of its financing costs & produce EPS equal to 0.
The financing costs involved in financial breakeven analysis consist of interest
payments & dividend payments to preferred stockholders. These financing
costs are fixed & in every case, they must be paid before dividends can be paid
to common stockholders.
Financial breakeven analysis deals with the lower section of the income
statement—the portion from operating income (EBIT) to earnings available to
common stockholders.
This portion of the IS is referred to as financing section because it contains
expenses associated with financing arrangements of firm.
Remember the financial breakeven point is defined as the level of EBIT where
EPS = 0.
Opr leverage considers how changing sales volume affects opr income;
whereas fin leverage considers how changing operating income affects EPS,
or earnings available to common stockholders.
Operating leverage affects operating section of the IS, whereas financial
leverage affects the financing section of IS.

The degree of financial leverage (DFL) is defined as the %age change in EPS
that results from a %age change in EBIT. DFL is computed as

More difficulty a firm has covering its fixed financing costs with operating
income, the greater its degree of financial leverage.

The higher the DFL for a particular firm, it can be concluded the closer the
firm is to its financial breakeven point, and the more sensitive its EPS is to a
change in operating income.

Greater sensitivity implies greater risk; thus, it can be stated that firms with
higher DFLs generally are considered to have greater financial risk than firms
with lower DFLs.
Analysis of operating leverage and financial leverage has shown that:
1. The greater the degree of operating leverage, or fixed operating costs
for a particular level of operations, the more sensitive EBIT will be to
changes in sales volume and
2. The greater the degree of financial leverage, or fixed financial costs for
a particular level of operations, the more sensitive EPS will be to
changes in EBIT.
• So, if a firm has high both opr leverage and fin leverage, then even
small changes in sales will lead to wide fluctuations in EPS.

DEGREE OF TOTAL LEVERAGE (DTL)

The degree of combined (total) leverage concept is useful primarily for the insights it
provides regarding the joint effects of operating and financial leverage on earnings per
share.

USING LEVERAGE AND FORECASTING FOR CONTROL

If Unilate does not meet its forecasted sales level, leverage will result in a magnified loss in
income compared with what is expected.

This will occur because production facilities might have been expanded too much,
inventories might be built up too quickly, and so on; the end result might be that the firm
suffers a significant income loss.

This loss will result in a lower-than-expected addition to retained earnings, which means the
plans for additional external funds needed to support the firm’s operations will be
inadequate.

Likewise, if the sales forecast is too low, then, if the firm is at full capacity, it will not be able
to meet the additional demand, and sales opportunities will be lost—perhaps forever.
The forecasting and control functions described in this chapter are important for several
reasons.
1. If the projected operating results are unsatisfactory, management can ‘‘go back to
the drawing board,’’ reformulate its plans, and develop more reasonable targets for
the coming year.
2. It is possible that the funds required to meet the sales forecast simply cannot be
obtained; if so, it obviously is better to know this in advance and to scale back the
projected level of operations than to suddenly run out of cash and have operations
grind to a halt.
3. Even if the required funds can be raised, it is desirable to plan for their acquisition
well in advance.
4. Any deviation from projections needs to be dealt with to improve future forecasts &
the predictability of the firm’s operations to ensure that firm’s goals are being
pursued appropriately.