Monday, May 3, 2010
Depreciation and the Break Even Point
Depreciation is a non-cash item. However, it is one of the major components of a business entity’s fixed cost and it is very important to understand how depreciation can affect the financial health of the business. On the other hand, breakeven point (BEP) is the defining factor whether an activity or a transaction will achieve a positive profit or not. This point equals to the total cost, both fixed and variable.
Depreciation is very important in determining the feasibility and profitability of a certain investment using the breakeven analysis. Being a fixed cost, depreciation must also be recovered before a breakeven point can be achieved. The higher the depreciation, the more units are needed and the greater contribution margin is needed to break even. Given the amount of depreciation and other fixed costs and a product’s contribution margin, a company may forecast through a break even analysis the quantity and amount of sales needed to gain a profit. In the short run, depreciation has a linear correlation with the breakeven point and it is generally an “uncontrollable cost” (Horngren, 1997) or a fixed cost. Higher depreciation increases total fixed costs resulting to higher sales needed to break even. In this regard, a lower breakeven point is not easy to achieve when there is a high level of depreciation.
Determining the depreciation method to be used is also an important decision that an entity must make. When determining the BEP, especially with the present value factor imputed in it, a straightline method of depreciation applied would yield a very different result compared to the amount when the declining balance method of depreciation is used.
Moreover, it is worth noting that when an entity is interested in the cash breakeven point of its sales or any transaction or in an investment decision, depreciation is a factor that needs to be considered. As mentioned, depreciation is a non-cash item and it would not be part of the fixed cost if the cash breakeven point is to be determined. Lastly, depreciation is considered as a tax shield. Thus, it matters very much whether the breakeven point to be determined is before or after interests and taxes.
References
Horngren, Charles T., George Foster, and Srikant M. Datar. Cost Accounting: A Managerial Emphasis. Upper Saddle River, NJ: Prentice Hall, 1997.
Instructions:
How does depreciation (a fixed cost) impact a company’s break-even point?
Depreciation is very important in determining the feasibility and profitability of a certain investment using the breakeven analysis. Being a fixed cost, depreciation must also be recovered before a breakeven point can be achieved. The higher the depreciation, the more units are needed and the greater contribution margin is needed to break even. Given the amount of depreciation and other fixed costs and a product’s contribution margin, a company may forecast through a break even analysis the quantity and amount of sales needed to gain a profit. In the short run, depreciation has a linear correlation with the breakeven point and it is generally an “uncontrollable cost” (Horngren, 1997) or a fixed cost. Higher depreciation increases total fixed costs resulting to higher sales needed to break even. In this regard, a lower breakeven point is not easy to achieve when there is a high level of depreciation.
Determining the depreciation method to be used is also an important decision that an entity must make. When determining the BEP, especially with the present value factor imputed in it, a straightline method of depreciation applied would yield a very different result compared to the amount when the declining balance method of depreciation is used.
Moreover, it is worth noting that when an entity is interested in the cash breakeven point of its sales or any transaction or in an investment decision, depreciation is a factor that needs to be considered. As mentioned, depreciation is a non-cash item and it would not be part of the fixed cost if the cash breakeven point is to be determined. Lastly, depreciation is considered as a tax shield. Thus, it matters very much whether the breakeven point to be determined is before or after interests and taxes.
References
Horngren, Charles T., George Foster, and Srikant M. Datar. Cost Accounting: A Managerial Emphasis. Upper Saddle River, NJ: Prentice Hall, 1997.
Instructions:
How does depreciation (a fixed cost) impact a company’s break-even point?
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