College of Agriculture
MANAGEMENT STRATEGIES THROUGH BREAKEVEN ANALYSIS
Washington State University
Pullman, WA 99164
Marginal Income
One approach to this improved understanding of
break-even analysis utilizes a marginal incomemarginal investment chart. The typical, break-even
chart is shown in Exhibit 1, where total revenue and
total cost are plotted against sales volume. Fixed
expenses, of course, are those incurred irrespective
of
sales
volume,
e.g.,
depreciation,
plant
maintenance, and related forms of overhead. Total
cost is the summation of fixed expenses and variable
costs, i.e., those which vary proportionately with sales
volume. As shown, the break-even point as achieved
at a sales volume of $4,000 and maximum profit is
reached when the budgeted sales volume of $6,000
is achieved. Using this classical chart, we may now
construct a marginal income chart by simply
subtracting variable costs from sales volume. For
analysis purposes, marginal income is depicted as a
percentage or ratio of sales dollars, see Exhibit 2. In
Exhibit 2, the marginal income ratio is 25%, i.e., 25
cents
of
every
sales
dollar
Of all those methodological tools available to the
modern manager, break-even analysis is by far the
most used within the agribusiness industry for
purposes of budgeting and long-range planning.
Methodologically, break-even analysis is simple to
apply, logically appealing, and readily applicable to
agribusiness situations. Once constructed, the breakeven chart provides management with a convenient
guide for judging operational performance, adjusting
pricing levels, or controlling cost components. Where
used for planning purposes, the cost-revenue
relationships are extended into future periods, subject
only to the constraints of competition or plant
capacity. Traditionally, this capacity constraint is
measured in physical units and expressed in relation
to what the competitive market will absorb or what the
plant is capable (in an engineering sense) of
producing.
It is when dealing with this capacity constraint that
managerial conflicts might evolve. That management
which is operationally oriented will base the breakeven analysis on the profit and loss data with a
capacity constraint composed only of market
absorption or physical plant limits. Those in
management who are financially oriented, however,
will look more closely on balance sheet items and
consider the break-even chart in light of its impact on
receivables, inventories, and available working
capital. From this managerial philosophy, capacity
must not be based on market or the plants' physical
limits, but should rather be measured by the limits
placed on working capital and related financial
resources. In the past, the operational and financial
arms of management may have operated nearly
independent of one another. However, with the rising
cost of debt capital and economic decisions resulting
in possible capital shortages, the two management
functions
have
become
increasingly
more
interdependent. Moreover, the agribusiness industry
can no longer afford this dichotomy of understandings
as they relate to capacity. A new definition of capacity
is needed -- one which will illustrate the
interdependence between physical and financial
capacity.
Exhibit 1
Break-Even Chart
$6,000
ue
st
en
v
Co
Re
al
t
l
o
T
ta
To
$4,000
$3,000
(Loss)
$2,000
$1,000
Budgeted Sales
Costs, Revenues, Profits
(Profit)
$5,000
Break-Even Point
Cooperative Extension
Fixed Expense
0
0
1
2
3
4
Sales Volume ($000)
WASHINGTON STATE UNIVERSITY & U.S. DEPARTMENT OF AGRICULTURE COOPERATING
1
5
6
1.0
Exhibit 2
Marginal Income Chart*
Profit
.5
Sales Volume ($000)
0
1
.5
1.0
n
rgi
Ma
2
o
ati
eR
m
o
Inc
3
%
25
4
Fixed Expense
5
.5
Decrease
S.V.
0
1
2
3
5%
I. 2
M.
5%
.5
I. 2
M.
5%
Increase
I. 2
M.
4
5
6
S. B.
B.T.P.
Increase
F. Exp.
1.0
Exhibit 3
Marginal Income Chart
(Fixed-Expense Variation)
1.5
1.0
Decrease
6
Sales Budget
Fixed Expense
Before-Tax Profit
represents a contribution towards fixed expense and
profit. As shown, every dollar of sales beyond the
break-even point will yield a profit of 25 cents and
every dollar of sales below this point reduces unpaid
fixed expenses by 25 cents. Quite obviously, those
factors having an impact on profit are fixed expenses,
marginal income, and sales volume. Variations in any
of these factors will have a direct impact on the level
of profit generated.
1.5
1.5
1.5
Exhibit 4
Marginal Income Chart
(Marginal Income Variation)
1.0
2.0
F. Exp.
Exhibits 3, 4, and 5 are included to demonstrate the
nature of this factor impact on profit. For example, as
shown in Exhibit 3, variation in fixed expense does
not affect the slope of the marginal income ratio line,
but it does affect its point of origin. As shown, profit is
directly affected by the absolute dollar adjustment, up
or down, of fixed expense.
I.
M.
S.V.
0
1
2
3
4
5
.5
%
25
Decrease
6
S. B.
B.T.P.
Increase
.5
1.0
The impact of a variation in marginal income ratio
while fixed expense and sales volume remain
constant is shown in Exhibit 4. By increasing the ratio,
the sales volume needed to break even is decreased
and profit as the budgeted, sales volume level is
increased. Increasing this ratio might be
accomplished by changes in price, variable costs, and
product mix. Improvement in any one of these
categories increases the slope angle.
1.5
Marginal Investment
Above, it has been shown that under break-even
analysis the concept of marginal income can be
developed as a ratio of dollars of contribution to profit
and overhead per dollar of sales. Using a similar
procedure, working capital requirements can be
developed as a ratio of dollars of investment required
per dollars of sales. A
With a constant, marginal-income ratio and fixed
expense, Exhibit 5 illustrates how a firm's profit
potential can he enhanced by increasing budgeted
sales volume. Quite obviously it would be desirable to
expand the budgeted sales volume as long as the
increased profit of 25 cents per dollar of sales exists.
Unfortunately, even if cash flow permits continuous
expansion of budgeted sales volume, physical plant
capacity places some limits on this possibility.
*See "Plant Capacity: Physical or Financial," E. J.
Renner, Management Review, February 1976, pp.
6, 8, 10, 12.
WASHINGTON STATE UNIVERSITY & U.S. DEPARTMENT OF AGRICULTURE COOPERATING
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the concept of marginal income, an increment of
investment (working capital) is required for every
increase in dollar sales.
Exhibit 5
Marginal Income Chart
(Volume Variation)
1.5
The marginal investment ratio is equally simple to
arrive at, i.e., we are searching for the working capital
increment required to support each dollar's sales. At
the budgeted sales volume in our exhibit of $6,000,
the working capital requirement of $1,800 would
suggest a ratio of .30. The slope of this ratio line, of
course, is dependent on management's control over
the current assets and liabilities, such as, inventory,
receivables, payables, accruals, etc.
Decrease
S.V.
2
3
5%
I. 2
M.
.5
4
5
6
S. B.
1
Increase
0
1.0
Physical Plant Capacity
Increase
.5
Decrease
7
Favorable
adjustments
in
working
capital
requirements lowers the line slope and unfavorable
changes increase it. As shown in Exhibit 7, reducing
the working capital requirement per dollar sales could
result in a marginal investment ratio of .25. Referring
to earlier exhibits, wherein budgeted sales were set at
$6,000 and the plant's productive capacity was
$7,000, the working capital required to support the
1.5
Exhibit 6
Marginal Investment Chart
1.5
%
30
nt
e
stm
ve
n
I
l
na
rgi
Ma
1.0
05
2.0
Sales Budget
Working Capital.
Working Capital Required
Exhibit 7
Marginal Investment Chart
(Working Capital Variation)
%
%
33
v.
. 30
n
I
Inv
.
.
M
M
1.5
5%
I. 2
M.
1.0
0.
1
2
3
4
Sales Volume
5
6
W.C.
Fixed
Assets
Total Investment
2.0
0.5
F. A.
marginal investment chart such as that shown in
Exhibit 6 can be constructed to show those variables
of the balance sheet in much the same manner that
the marginal income chart demonstrated variables on
the profit and loss statement. Sales volume, for
example, is again plotted on the horizontal plane.
Corporate investment, comprised of fixed assets and
working capital, is plotted on the vertical axis on much
the same basis as we had previously plotted total
costs, comprised of variable and fixed expenses.
05
S. B.
F. Exp.
B.T.P.
1.0
S.V.
0.
1
2
3
4
5
6
0.5
physical capacity (extending M. Inv. ratio line until it
intersects the vertical line) arising from a sales
volume of $7,000 would be $2,100, see Exhibit 8.
Now let's assume this particular agribusiness firm has
a limit of $1,500 on its available working capital. This
working capital ceiling can be illustrated as shown in
Exhibit 9. Confronted with this limit and a marginal
investment ratio of 30%, the firm's sales volume
potential has been reduced to $5,000. In other words,
the budgeted sales volume and the plant's physical
capacity are no longer relevant. Despite the fact that
our marginal income analysis suggests a desired
sales volume of $6,000 or $7.000, the constraint on
working capital available has tied "capacity" to but
Fixed assets, of course, are comprised of physical
facilities and remain fixed unless decisions are made
to substantially increase or decrease productive
capacity. Much like the fixed expenses, these assets
do not generally vary with volume nor over a day-byday basis. Working capital, however, does vary with
volume and (like variable expenses) will adjust
directly to increases or decreases in sales. Similar to
WASHINGTON STATE UNIVERSITY & U.S. DEPARTMENT OF AGRICULTURE COOPERATING
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Exhibit 8
Marginal Investment Chart
(Sales Volume Variation)
relationship of each and the impact this association
has on the planning process. As shown in Exhibit 10,
the conflict between a physical vs. financial concept
of capacity is readily apparent. Management which
relates capacity (i.e. follow the marginal investment
ratio line to a desired sales volume of $5,000 and a
before-tax profit of $250. In this case, the financial
constraint is most limiting and would take
precedence. In another situation, however, plant
capacity might provide the major limit. As shown in
Exhibit 10, plant capacity and a before-tax profit of
$750 could only be reached if the marginal
investment ratio line were reduced to .214. Given this
knowledge, management can now begin to search for
means by which current assets and liabilities could be
effectively reduced.
2.0
1.5
%
30
v.
n
I
M.
05
S.B.
S.V.
0.
F.A.
1
2
3
4
5
6
7
0.5
(To be continued in next issue)
$5,000. In fact, if this firm were to secure its budgeted
sales volume, the marginal investment ratio would
have to be reduced to .25, and if it were to utilize its
plant at full production capacity, a further reduction in
ratio to .214 would be necessary.
Sincerely,
Ken D. Duft
Ken D. Duft
Extension Economist
By combining our analysis of marginal income and
marginal investment on a single chart, management
can now readily perceive the interdependent
Exhibit 9
Marginal Investment Chart
(Working Capital Ceiling)
Exhibit 10
Marginal Income-Investment Chart
(Physical vs. Financial Capacity)
2.0
2.0
0.5
1
2
3
4
5
6
7
Before-Tax Profit
Working Capital.
1.5
1.0
05
0.
Fixed Assets
F.A.
0.
Sales Volume
Fixed Expenses
05
.
Inv
M.
%
1.4
v. 2
n
I
M.
30% M.I.
v.
In
M.
%
30
Capacity at
W.C.
1.0
Plant Financial
%
25
Budgeted Sales
1.5
Plant Physical Capacity
Working Capital Limitation
0.5
-1.0
Working Capital Limitation
%
1.4
I. 2
.
M
Before-Tax Profit
%
30
v.
Before-Tax Profit
In
.
M
Sales Volume
1
5%
I. 2
M.
2
3
4
Fixed Expenses
-1.5
WASHINGTON STATE UNIVERSITY & U.S. DEPARTMENT OF AGRICULTURE COOPERATING
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Physical Plant Capacity
W. C.
1.0
5
6
7