In capital budgeting
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Break even analysis is a special application of sensitivity analysis. It aims at finding the value of individual variables which the project’s NPV is zero. In common with sensitivity analysis, variables selected for the break even analysis can be tested only one at a time.
The break even analysis results can be used to decide abandon of the project if forecasts show that below break even values are likely to occur.
In using break even analysis, it is important to remember the problem associated with sensitivity analysis as well as some extension specific to the method:
- Variables are often interdependent, which makes examining them each individually unrealistic.
- Often the assumptions upon which the analysis is based are made by using past experience / data which may not hold in the future.
- Variables have been adjusted one by one; however it is unlikely that in the life of the project only one variable will change until reaching the break even point. Management decisions made by observing the behavior of only one variable are most likely to be invalid.
- Break even analysis is a pessimistic approach by essence. The figures shall be used only as a line of defense in the project analysis.
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By inserting different prices into the formula, you will obtain a number of break even points, one for each possible price charged. If the firm changes the selling price for its product, from $2 to $2.30, in the example above, then it would have to sell only (1000/(2.3 – 0.6))= 589 units to break even, rather than 715.
Bold textTo make the results clearer, they can be graphed. To do this, you draw the total cost curve (TC in the diagram) which shows the total cost associated with each possible level of output, the fixed cost curve (FC) which shows the costs that do not vary with output level, and finally the various total revenue lines (R1, R2, and R3) which show the total amount of revenue received at each output level, given the price you will be
The break even points (A,B,C) are the points of intersection between the total cost curve (TC) and a total revenue curve (R1, R2, or R3). The break even quantity at each selling price can be read off the horizontal, axis and the break even price at each selling price can be read off the vertical axis. The total cost, total revenue, and fixed cost curves can each be constructed with simple formulae. For example, the total revenue curve is simply the product of selling price times quantity for each output quantity. The data used in these formulae come either from accounting records or from various estimation techniques such as regression analysis.