Principles of Managerial Finance

breakeven analysis
Indicates the level of operations
necessary to cover all operating
costs and the profitability associ-
ated with various levels of sales.

operating breakeven point
The level of sales necessary to
cover all operating costs;the
point at which EBIT$0.

CHAPTER 12 Leverage and Capital Structure 509

1. Quite often, the breakeven point is calculated so that it represents the point at which all operating and financial
   costsare covered. Our concern in this chapter is not with this overall breakeven point.


2. Some costs, commonly called semifixedor semivariable,are partly fixed and partly variable. An example is sales
   commissions that are fixed for a certain volume of sales and then increase to higher levels for higher volumes. For
   convenience and clarity, we assume that all costs can be classified as either fixed or variable.

TABLE 12.2 Operating Leverage, Costs, and

Breakeven Analysis

Algebraic

Item representation

Sales revenue (PQ)

Operating leverage

Less: Fixed operating costs  FC

Less:Variableoperatingcosts (VCQ)

Earnings before interest and taxes EBIT

Breakeven Analysis

Breakeven analysis,sometimes called cost-volume-profit analysis,is used by the

firm (1) to determine the level of operations necessary to cover all operating costs

and (2) to evaluate the profitability associated with various levels of sales. The

firm’s operating breakeven pointis the level of sales necessary to cover all operat-

ing costs.At that point, earnings before interest and taxes equals $0.^1

The first step in finding the operating breakeven point is to divide the cost of

goods sold and operating expenses into fixed and variable operating costs. Fixed

costsare a function of time, not sales volume, and are typically contractual; rent,

for example, is a fixed cost. Variable costsvary directly with sales and are a func-

tion of volume, not time; shipping costs, for example, are a variable cost.^2

The Algebraic Approach

Using the following variables, we can recast the operating portion of the firm’s

income statement given in Table 12.1 into the algebraic representation shown in

Table 12.2.

Psale price per unit

Qsales quantity in units

FCfixed operating cost per period

VCvariable operating cost per unit

Rewriting the algebraic calculations in Table 12.2 as a formula for earnings

before interest and taxes yields Equation 12.1:

EBIT(PQ)FC(VCQ) (12.1)

Simplifying Equation 12.1 yields

EBITQ(PVC)FC (12.2)