Breakeven Analysis - First Step to Understanding Profitability

Why?
Have you ever really thought about why an airline is willing to sell some seats at a deeply discounted fare on almost every flight?  What is the rationale for what seems to be suicidal pricing?  Airlines seem to go in and out of bankruptcy a lot so maybe this is why.

The slang term for why they do this is called the “full-bus theory.”  The reasoning is that an empty seat on take-off produces no revenue, so even getting a meager amount of revenue out of it is better than letting it go empty.  To make this work requires a good deal of data modeling on the part of the airline and a willingness to oversell seats and bump passengers if need be.  And, guess who gets bumped first…  Rest assured it is not the regular business traveler that pays higher fares because of the last minute nature of much business travel.  It is the low-fare passenger that is put into the next available seat and given a voucher for a future flight as compensation.  

Why doesn't the airline just roll out another airplane to service the overflow?  In those situations where a route is consistently bumping passengers the airline may add another flight to the daily or weekly schedule to accommodate the increased demand.  Otherwise, except in those markets where the airline is running a taxi or shuttle service, adding a flight on an ad hoc basis to address overflow simply won’t happen.  In addition to the regulatory issues, this would be financial suicide.  

Airlines have most of their financial problems when the economy contracts and they are left with increased amounts of excess capacity in the form of more empty seats.  Their only real choice is to reduce the number of flights and bump cheap-seat passengers when they oversell.  The cost of pilots, ground crews, fuel, depreciation, landing fees and the like for a single flight doesn’t change, regardless of how full the flight is.  On-board flight service personnel may be reduced if there are more empty seats but that is a small amount relative to the rest of the flight.  This is why they try to fill those empty seats with some revenue, even when times are good.  Even with this, the economic model for airlines leaves them very vulnerable to small downward changes in demand. 

Breakeven Analysis 
This airline example is a good illustration of the need for Breakeven Analysis (B/E) in that it promotes a thorough understanding of costs and their behavior at different levels of activity.  Like the airlines, you can use the information and knowledge produced by B/E to power pricing and resource allocation decisions.  The rest of this discussion addresses the objectives, concepts and mechanics used to generate B/E, but the use of B/E in capacity management and measurement is left for another day. 

B/E is intended to support the decision-making process and will give you the ability to:

1.    Measure the revenue necessary for the business to cover its expenses.  This drives pricing, budgeting and the allocation of scarce resources to competing alternatives.

2.    Better understand operational capacity and the impact of having more or less of it.  Having too much capacity can make actual unit costs too high whereas not enough capacity can inhibit growth. 

Costs
There are three types of costs that can be identified when examining any business:  Fixed, Step-Fixed and Variable.  While the real world is rarely so clear-cut, it is useful to understand costs in this context to better understand their behavior based on changes in activity.  

Fixed Costs
These costs do not change based on volume over a relevant range of activity.   In reality there are very few costs that never change, which is why it is important to correctly define the relevant range.  Good examples are rent and other occupancy costs that are under contract for some number of years into the future.  These costs may increase or decrease based on those contracts or other factors but they are known for a certain period of time into the future and will not change based on volume.  (Note:  Some rents in retail properties may change based on sales via an overage charge, which would make rent both a fixed and a variable cost.)

Step-fixed Costs
These costs are also referred to as capacity costs in that they represent a fixed amount of capacity that is used up as volumes increase.  Examples of this include digital storage space, the number of users that a server configuration will support, and trucks used to make deliveries.  Once that amount of capacity is used up the next amount of capacity is purchased making the cost of that next sale very high.   This poses a measurement and reporting problem in that unit costs and resulting margins can vary based on how much of the capacity is used at any given time.  This also creates an opportunity to better understand and control the cost of excess capacity over time.

Variable Costs
These are costs that vary directly with volume.   If volume goes up by 1 unit, these costs go up by the cost of 1 unit.  These costs are measured and controlled as a percent of revenue since their behavior makes such analysis meaningful.  They are predictable based on the level of sales so it is easy to know when they are not what they should be.  

Breakeven Point
The B/E point is where operating revenues exactly cover operating expenses.  Consider the following example as illustrated in the table and graph below.  

•    Variable costs are $5/unit of volume
•    Step-fixed costs are $15,000 for every 300 units, or $50 per unit at capacity
•    Fixed costs are $20,000, regardless of volume for the next 3 years
•    Unit price is $100.

Using this information to calculate revenues and costs at various volumes results in three breakeven points, as shown in the graph below.  This is a result of the large amount of step fixed costs in this model.  Note that just when the business became profitable at 600 units it had to add another 300 units of capacity at 601 causing the bottom line to go negative again until the next B/E point at 684.21 units sold.  After that the business is profitable but margins decrease each time more capacity is purchased.

  

be 1.jpg

The B/E Formula
The generalized formula for simple breakeven analysis is 'Total Fixed Costs' ÷ 'Margin %'.  'Total Fixed Costs' in this example are easy to identify - $20,000 – but what is the 'Margin %'?   The margin varies with each volume in the table because all of the step-fixed costs are included for the entire step, regardless of volume.  

To side-step this issue for a moment, we can calculate the 'Margin %' at full-capacity for each step.  At 300 units, for example, the Margin is 45% of sales.  (Revenue = $100, variable cost = $5 and step-fixed cost = $50.)  Based on this, breakeven should be $20,000 ÷ .45 = $44,444 (444.44 units), but this is different than the breakeven points shown in the table above.  Why?

Let’s look at what happens at 444.44 units.  The Margin at that volume is not 45% but rather 27.50%.  This is because the step-fixed costs used to calculate the 'Margin %' at 444.44 units include excess capacity of $7,778, as shown in the table below.  To have a margin of 45%, the same amount of step-fixed costs per unit has to be included, but not the excess capacity, also shown below.  The difference in the 'Op Income' shown below is the amount of excess capacity, which still ultimately has to be accounted but which can isolated and analyzed by using B/E analysis.  

 

Next Up:  Measuring and Managing Capacity