A systematic evaluation of the concept of break-even analysis and risk: A computer based empirical study

Abstract

It has been long understood that increasing profits are a justification for accepting increased risks. However, the development and presentation of the relationships between sales, variable expenses, fixed expenses and net income have received rather cursory and inadequate treatment in the finance literature in that the risk factor, although both readily available and measurable, is typically ignored. What the decision maker requires is not a series of ad hoc observations concerning only a simple relationships, but a systematic development and exploration of the factors that affect these relations. The decision maker needs is a dynamic framework to examine the interrelationships of sales, variable costs, fixed costs and risk so that return (profits) can be maximized at an acceptable level of risk. It has been shown that operating leverage is a good measure of operating risk. Specifically Lev (1) showed both at the analytical and empirical levels that as operating leverage increases (decreases), so does the overall and systematic volatility of the return on the firms stock. Using degree of operating leverage (DOL) as a surrogate for risk, this study sytematically explores and develops the impact the DOL on the break-even analysis and in turn evaluates the corollary role played by break-even analysis is influencing DOL. The study establishes these relationships in a microcomputer and spreadsheet framework and develops a series of tabular and graphical tools for the decisions maker. The use of these tools clearly illustrates the effect of the risk factor on the break-even relationship and demonstrates that these relations are dramatically nonlinear even though the investigation was simplified by assuming linear break-even analysis. The greatly increased sensitivity (in nonlinear terms) of profits to changes in the model clearly illustrate the necessity of including risk in an effort to optimize decisions. Although the decision maker may know intuitively that a business entity with increased operating leverage is far more vulnerable in learn years, the desire and/or necessity to increase profits through debt is always present. The model developed provides a framework that enables the decision maker to maximize profits at a given level of risk. The study utilizes a series of numerical examples and illustrates results in both a tabular and graphical format. The analysis is performed within a spreadsheet format. A listing of the model is available.