Break-Even Analysis – Definition

Definition of break-even: The point at which the net income generated from an investment decision has covered the costs.

You’ll often read the term ‘break-even’ in financial management books & corporate finance textbooks. It’s a word which is synonymous with the strategic decisions of financial managers.

What is break-even analysis?

Break-even analysis is a fairly straight forward way to assess a business or investment opportunity. It’s applicable to projects that generate financial returns, either through directly generating income, or producing a saving which can be quantified.

There are two ways to approach break-even analysis:

  • Time as an output
  • Price as an output

Time as an output

If a new franchise restaurant costs £300,000 to open, and once opened it produces £100,000 of profit per year, then simply speaking the break-even point is at 3 years. Said another way, after three years the investment will have broken even.

Three years with £100,000 of earnings will have fully covered the upfront cost.

Another way of phrasing break-even is, how long after investment will I be better off?

Take the question of whether to install solar panels on a roof. If the panel installation costs £15,000 and it will save a home-owner £1,500 in electricity bills each year, then the break-even point is 10 years.

This means that, compared to the scenario where the panels’ weren’t installed, you’d need to wait 10 years until you actually had more cash in the bank than if you’d forgone the purchase and kept the £15,000 in your savings. (This example assumes no interest is available on the savings).

To calculate break-even point:

Upfront investment cost / annual profit = Number of years until break-even is reached.

Break-Even Analysis - Definition
The definition of break-even analysis is an accounting concept

Price as an output

An alternative way of approaching the formulae is to consider what profit is required each year to reach break-even within a set period of time.

This time the formulae looks as follows:

Upfront investment cost / # years to break even = annual profit required

I don’t personally find this arrangement of the formulae as practical – because it’s unlikely that a user has a fixed break-even period required. The main use of this formulae is in exam questions.

Furthermore, profit is a function of the market price, which is not under the control of the business (unless they are a monopoly or oligopoly), therefore the company cannot know or control these variables in advance.

How is the phrase break-even used in a sentence?

“This capital expenditure will be large scale and require debentures to be issued to finance it, however, the project will break-even after just 4 years.”

“The business expects to have broken-even in 3 years, with an equity investment from a venture capital trust.”

What else you should know about break-even analysis?

In my opinion, break-even analysis is over simplified. It requires adjustment and more complexity before it can deliver useful results.

Let’s consider the example where a £300,000 upfront investment in a fast food franchise could deliver £100,000 profits per year. The weakness of a quick break-even assessment would be that:

Break-even analysis does not factor in the potential return from other uses of the funds.

  • Had we not invested in the fast-food restaurant, we could have earned a good return on other projects, or at least a positive return in a bank account.
  • This means that when the fast-food restaurant earns a cumulative £300,000, the investor is still worse off, as if they had put the £300,000 in a bank account, or the stock market it might be worth £350,000 by that point.
  • Therefore, break-even is an analysis that provides information about the individual return of an investment, but not about the relative performance of that investment versus an alternative.

Break-even analysis is not risk adjusted

  • Two fast food venues which break-even at the same date may have completely different risk profiles. Common sense, therefore, dictates that the lower-risk project would be optimal. The break-even analysis on its own, however, wouldn’t be able to suggest this.

Break-even analysis promotes simplistic finance theory

Break-even analysis can promote faulty logic. It gives the impression that:

  • Investment costs are sunk costs and are gone forever.
  • Profits will begin to compensate the investor. At the break-even point, they have finally earned all those sunk costs back.
  • From this point onwards, the project is simply ‘pure profit’ for the investor, as all of their costs have been paid for.

This might be the case from a cash flow perspective, but it ignores the following points:

The investment may require an upfront investment, but this isn’t a loss to the investor. Once the fast-food restaurant is built, in theory, they have an asset sat there worth approximately £300,000.

Therefore the initial profits aren’t clawing back the investor from a hole – they’re just the beginning of a £300,000 asset producing a return.

From this perspective, there’s nothing special about the break-even point. The year before and the year after, will hopefully just be a reasonable cash return on £300,000 of capital invested.

The later years are not a ‘pure profit’, i.e. a bonus for the investor to just accept and be thankful for. The investor must ensure that the returns from the restaurant justify the £300,000 of capital they have remained invested in the project. There’s still much at stake. If the investor does continue to receive a good return from the restaurant, then they’re failing to use their capital effectively.

If the investor believes they could later get a better return elsewhere, they might consider selling the restaurant and using their capital on a different project. This is always an option. Investors would be missing out if they just treated any profits after break-even as a bonus.

How does the definition of break even relate to investing?

Break-even is not a common measure used by investors to measure the returns from their portfolio. The weighted average annual return is a far more useful measure which takes into account the amount of capital invested per year.

If you invested £1,000 for example, you’d want to understand what historical rates of return you could get by investing in different asset classes such as shares and corporate bonds. Calculating a break-even period would provide you with data worth comparing to these other asset classes.

An investor is more likely to come across the break-even concept when businesses are explaining the business case for new investment into efficiency or productivity-boosting equipment.

Leave a Reply

Your email address will not be published. Required fields are marked *