Break-Even Analysis

An analysis identifying the point at which the costs and benefits, or revenues, of an activity are equal.

Source: Horngren, Datar & Rajan 2015

Costs are separated into those that do not vary with volume and those that do. The amount each unit of activity contributes towards the fixed costs is the revenue it brings less the variable cost it incurs. Dividing total fixed costs by that contribution per unit gives the volume at which total contribution exactly covers fixed costs and the activity neither gains nor loses. Above that volume each additional unit adds its full contribution to the result.

Source: Horngren, Datar & Rajan 2015

Because fixed costs do not change with volume, so allocating a share of them to each unit produces a figure that varies with the volume assumed and cannot be used to decide about volume. Contribution isolates what each additional unit actually adds, which is what a decision to do more or less of something turns on. A service showing a loss after fixed costs are allocated may still be worth running if its contribution is positive, since withdrawing it would leave the fixed costs in place with nothing offsetting them.

Source: Horngren, Datar & Rajan 2015

Margin of safety is the distance between expected activity and the break-even volume, expressed as the fall in activity the service could absorb before it began to lose money. Operating leverage describes how sharply the result responds to changes in volume, and it rises with the share of costs that are fixed. A service with high fixed costs and low variable costs is highly leveraged, so modest changes in activity produce large swings in its financial position in both directions.

Source: Gapenski 2015

It is used to test whether a proposed service can reach a viable volume, to establish the minimum activity a session or clinic must achieve to justify running it, and to assess how exposed an existing service is to a fall in referrals. It also informs decisions about whether to run additional sessions, since the relevant comparison is between the contribution earned and the incremental cost of opening the session rather than its allocated full cost.

Source: Gapenski 2015

It assumes costs are either fixed or proportional to volume, when much of health cost is neither and steps up in blocks as capacity thresholds are crossed. It assumes a constant mix of cases, so a service treating more complex patients at the same volume will not behave as predicted. It applies to a short horizon within which capacity is genuinely fixed. Used beyond these conditions it produces a clean number resting on a description of cost behaviour that does not hold.

Source: Horngren, Datar & Rajan 2015