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Financial Analysis With Microsoft Excel-Mayes, Shank - Chapter 6

CHAPTER 6 Break-Even and Leverage Analysis Differentiate between fixed and variable costs. Calculate operating and cash break-even points, and find the number of units that need to be sold to reach a target level of EBIT. Define the terms “business risk” and “financial risk,” and describe the orgins of each of these risks. | 6 Break-Even and Leverage Analysis After studying this chapter you should be able to 1. Differentiate between fixed and variable costs. 2. Calculate operating and cash break-even points and find the number of units that need to be sold to reach a target level of EBIT. 3. Define the terms business risk and financial risk and describe the orgins of each of these risks. 4. Use Excel to calculate the DOL DFL and DCL and explain the significance of each of these risk measures. 5. Explain how the DOL DFL and DCL change as the firm s sales level changes. In this chapter we will consider the decisions that managers make regarding the cost structure of the firm. These decisions will in turn impact the decisions they make regarding methods of financing the firm s assets i.e. its capital structure and pricing the firm s products. In general we will assume that the firm faces two kinds of costs 1. Variable costs are those costs that are expected to change at the same rate as the firm s sales. Variable costs are constant per unit so as more units are sold total variable costs will rise. Examples of variable costs include sales commissions costs of raw materials hourly wages etc. 163 164 Break-Even and Leverage Analysis 2. Fixed costs are those costs that are constant regardless of the quantity produced over some relevant range of production. Total fixed cost per unit will decline as the number of units increases. Examples of fixed costs include rent salaries depreciation etc. Figure 6-1 illustrates these costs.1 Figure 6-1 Total Fixed and Total Variable Costs Units Produced Break-Even Points We can define the break-even point as the level of sales either units or dollars that causes profits however measured to equal zero. Most commonly we define the break-even point as the unit sales required for earnings before interest and taxes EBIT to be equal to zero. This point is often referred to as the operating breakeven point. Define Q as the quantity sold P is the price per unit V .