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The Breakeven Point is a Return on Investment analysis that determines the number of units or amount of sales that are needed to accumulate enough benefit to pay for the cost of the project.
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Quick reference
Breakeven Point
The Breakeven Point is a Return on Investment analysis that determines the number of units or amount of sales that are needed to accumulate enough benefit to pay for the cost of the project.
When to Use Breakeven Point
Like all project ROI techniques, this analysis is done as part of the preparation of the business case used to justify a project. Breakeven Point ROI analysis is a market focused analysis. This technique is normally used with projects that are creating new products or services for sale. The question often asked is whether the market is big enough to provide buyers for that many units. This technique does not work well when there are large operating expense costs and benefits that continue year after year. It is difficult to know how many years of those costs and benefits should be included.
Instructions
This ROI technique is the least dynamic of the ROI techniques. There is no formal time dependency in the technique. However, there is a market dependency. The result of the analysis is the number of units that must be sold at an assumed price. With this analysis the business then turns to sales and marketing and asks the questions, “Is the market big enough?” and “Can we sell that many?” Unless the answer to both questions is a resounding, “Yes!” the project should be cancelled.
This analysis can be done using the ROI spreadsheet that we illustrated in the module on ROI. However, for this analysis, we often do not need to spread the costs and benefits across the years. Since there is no time component in this calculation, that work is not needed. Cost should be entered as negative numbers and benefits should be entered as positive numbers. When entering costs, if you have large operating expenses costs or benefits, you should not use this technique. If these costs are small relative to the sales costs and benefits, then include one year’s worth of these costs.
The basic formula for this analysis is:
Gross Profit – Operating Expense = 0
However there are several components in each of those terms. The Gross Profit term has a price component, a sales volume variable (this is what we solve for) and a variable cost per unit. The Operating Expense term includes all project costs, other operating expenses and benefits for an assumed time period (I normally use one year). That makes the equation:
(# units sold x price) – (# units built x COGS) – (project costs) – operating (costs – benefits) = 0
Most of these numbers are on the ROI spreadsheet and those that are missing can be easily determined based upon project assumptions. Let’s look at an example. In this case “A” will represent the number of units that must be sold to hit the Breakeven Point.
Notice in this example there was no Operating Expense impact beyond the project cost. Also, in this example an additional 25 units had to be built for manufacturing inventory reasons. That effect may or may not be needed for your projects.
Hints and Tips
- This technique will tell you how many units you need to sell, but it does not tell you how large the market is. Your sales may fully saturate or barely penetrate the market, which means the long term potential is not evaluated using this technique.
- I find this to be an excellent technique for evaluating product line extensions and “one-off” products. For those circumstances there is often a limited market and this technique is an excellent method for evaluating whether the product line will ever make money or not.
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