From the course: Accounting Foundations

Breakeven analysis: Interpretation and use

From the course: Accounting Foundations

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Breakeven analysis: Interpretation and use

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- In the previous movie where we talked about the charity banquet, the $18,000 fixed cost of the car divided by $210 per person that the charity gets to keep, means that 86 people need to come to the banquet in order for the banquet to break even. Now, that's very interesting and a good useful number. Okay. Do you think that the charity performed this simple break even calculation? You can see it's not that difficult. Did they do it? No, they did not. When I said to my wife, Ramona, "Well, you must have 86 people come to the charity banquet to break even." She said, "What are you talking about?" It hadn't even crossed the minds of the planning committee that they had to have a certain number of people come to the charity banquet for it to break even. So why didn't they think of doing this simple break even analysis? Well, many people think that numbers are boring, starting a business or organizing a charity banquet. Now that's fun, that's exciting. But numbers, those are boring. Plus some people are afraid of numbers. Numbers are scary, and many people just don't even think of using data in making decisions. This is why we need to know a little bit more about accounting because it helps us structure our decisions a little bit better. Ramona and her planning committee hadn't even thought about this break even number. It is a good practice to gather data and do some analysis when making decisions. Okay? People always ask me at this point, "So what happened? What happened at the charity banquet?" Well, here's the bad news, at least for me, from an accounting standpoint, I've been trying to inculcate into my wife Ramona, the importance of these accounting computations for low these many years. But she just goes ahead and ignores me in my calculations, and the problem is that she's always successful anyway, With respect to this banquet, they had hundreds of people attend. They made a whole gove of money. Ramona wondered what I was worrying about with my little break even calculations. So I lost my credibility with her, but hopefully I haven't lost my credibility with you. It's at least worth checking the numbers to make sure that you've got a chance of breaking even. One huge benefit of financial analysis in general and break even analysis in particular, is that it can counteract the natural overoptimism of entrepreneurs. Now, don't get me wrong, I'm not saying that accounting numbers can make all your decisions for you. In the end, you still have to make the judgment call. Should we do the charity banquet or not? Should we open the scuba shop in the mall or not? Should we build a new restaurant in this location or not? You've got to make that business decision. But the accounting numbers, in this case, the breakeven analysis can at least help you identify ideas that are really bad, that have no hope of working, and can also help you identify ideas that are almost certain to work. You'll find that most decisions are somewhere in the middle, and you've got to use your judgment, but at least the accounting analysis has helped you structure the decision and has forced you to gather data so that you're not making a decision based on just your optimistic view of life as an entrepreneur. By the way, one of these days, Ramona's judgment will lead to a bad decision, and I'll be able to say to her, "See, I told you so. You should have paid attention to my accounting analysis." But that day hasn't come yet. Break even analysis is a very simple, intuitive way to understand business decisions.

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