In class rooms, calculating break-even point is usually easy when the all of the required data is available and ready to be processed. However, it is not as straightforward for an external entity to calculate a company’s break-even since they have only access to publicly available financial statements. Analyzing break-even from external financial statements may not be as straightforward due to several reasons.
Analyzing Break-even from External Financial Statements
External financial statements are organized based on absorption costing, which is a costing method that assigns all manufacturing costs to the product as it is being produced (Whitecotton et al., 2019) such as job-order costing and process costing. While for internal management decision-making, managers usually need information based on the cost behavior, which is variable costing. However, the information is usually available only for internal use.
As an external entity that wants to assess whether a company is operating at break-even or not, we can only rely on the key financial statements available for the public, such as the balance sheet, income statement, or statement of cash flows. However, the number on these financial statements, which used absorption costing, doesn’t necessarily identical to the contribution income statement, which used variable costing. Absorption costing income statements can be confusing and are easily misinterpreted (Garrison et al., 2017).
Also read about Users of Financial Statements
Intuitively, we can check on many lines in the financial statements, such as the net cash from operating activities in the Statement of Cash Flows, operating income in the Income Statement, or retained earnings in the balance sheet. If a company does not achieve break-even, the value on those lines in each financial statement will most likely result in a negative value, since its revenues will not be enough to cover the operating expenses.
However, it may not be as straightforward as our intuition tells us. Retained earnings in the balance sheet can be positive if its beginning balance is high enough to cover the loss of the underperforming operation. Operating income and net cash from operating activities can also be misinterpreted if there are significant inventory changes from the previous period, which will be recorded differently in absorption costing and variable costing.
Garrison et al. (2017) stated that net operating income from absorption costing (i.e. from Income Statement) may differ from the net operating income from variable costing (i.e. from Contribution Income Statement). These differences appear because absorption costing capitalized some fixed manufacturing overhead into inventories rather than being immediately expensed on the income statement, as is the case in variable costing.
Thus, during a period, if the inventories increase, absorption costing will defer some of the fixed manufacturing overhead in the period into ending inventories. This will result in a higher net operating income in absorption costing than the net operating income in variable costing. On the contrary, if the inventory decrease because the units produced is less than the units sold, then the absorption costing will record lower net operating income than the variable costing. Operating income will be exactly the same in both of the costing methods if a company uses just-in-time inventory, and therefore has no beginning or ending inventory (Heisinger & Hoyle, n.d.).
The inventory changes must be considered when an external entity wants to analyzing break-even from the external financial statements. Generally, this is true whenever an external entity wants to analyze a company related to its cost-volume-profit analysis using publicly available financial statements. The net operating income from both costing methods can be reconciled by determining how much the fixed manufacturing overhead was deferred in or released from inventories during the period.
References Garrison, R., Noreen, E., & Brewer, P. (2017). Managerial Accounting (16th ed.). McGraw-Hill Education. Heisinger, K., & Hoyle, J. B. (n.d.). Accounting for Managers. https://2012books.lardbucket.org/books/accounting-for-managers/index.html Whitecotton, S., Libby, R., & Phillips, F. (2019). Managerial Accounting (4th ed.). McGraw-Hill Education.