Uses for the Accounting Break Even

Why would anyone be interested in knowing the accounting break-even point? To illustrate how it can be useful, suppose we are a small specialty ice cream manufacturer with a strictly local distribution. We are thinking about expanding into new markets. Based on the estimated cash flows, we find that the expansion has a positive NPV.

Going back to our discussion of forecasting risk, we know that it is likely that what will make or break our expansion is sales volume. The reason is that, in this case at least, we probably have a fairly good idea of what we can charge for the ice cream. Further, we know relevant production and distribution costs with a fair degree of accuracy because we are already in the business. What we do not know with any real precision is how much ice cream we can sell.

Given the costs and selling price, however, we can immediately calculate the breakeven point. Once we have done so, we might find that we need to get 30 percent of the market just to break even. If we think that this is unlikely to occur, because, for example, we have only 10 percent of our current market, then we know our forecast is questionable and there is a real possibility that the true NPV is negative. On the other hand, we might find that we already have firm commitments from buyers for about the breakeven amount, so we are almost certain we can sell more. In this case, the forecasting risk is much lower, and we have greater confidence in our estimates.

There are several other reasons why knowing the accounting break-even can be useful. First, as we will discuss in more detail later, accounting break-even and payback period are very similar measures. Like payback period, accounting break-even is relatively easy to calculate and explain.

Second, managers are often concerned with the contribution a project will make to the firm's total accounting earnings. A project that does not break even in an accounting sense actually reduces total earnings.

Third, a project that just breaks even on an accounting basis loses money in a financial or opportunity cost sense. This is true because we could have earned more by investing elsewhere. Such a project does not lose money in an out-of-pocket sense. As described in the following pages, we get back exactly what we put in. For noneconomic reasons, opportunity losses may be easier to live with than out-of-pocket losses.

0 0

Post a comment