Mind Your Business - 18 November 2008
Break-even analysis: Eurotunnel
At the heart of the issues that faced Eurotunnel was that of break-even. Any new business or existing company starting up a new venture has to incur costs in setting up the business before any customers 'walk through the door' and start paying for its goods or services. The early months and years of many businesses therefore will be one in which they will have debt. The success of the business might rely on how effectively the company is able to meet that debt. Break-even analysis can be seen as a planning tool to aid businesses in assessing when they will generate sufficient revenue from sales to cover the total costs of production and move into profit.
At its simplest level, therefore, break-even occurs at an output/sales level where total revenue = total costs. More formally, we can use the following formula to calculate break-even:
Break Even Point = Fixed Costs ÷ Contribution
Where the contribution represents the selling price - variable costs.
Costs are therefore one crucial element in break-even. Variable or direct costs are those costs incurred during production, they vary with the amount produced, rising as output rises and falling as output falls. Eurotunnel's variable costs are relatively low since the cost of operating the tunnel now it is built is relatively low.
Fixed costs or overheads or indirect costs are those costs that do not depend on output. This does not mean that they do not change, they do, but they do not vary with the amount produced. These costs can be insurance, administrative costs, advertising and marketing costs and, very relevant in the case of Eurotunnel, interest payments. In general, a firm must seek to cover its operating (variable) costs in the short term - after all, if it is not generating enough revenue from sales to cover the costs of producing its product it does not have much of a future! Ultimately, howeveer, it must cover both its fixed costs and its variable costs - in other words cover total costs. Once it does this, the business moves into profit.
This can be shown using a diagram as above. On the vertical axis is costs/revenue, output/sales are on the horizontal. Notice that the variable cost curve (VC) starts at 0 – if the firm produces no output then its VC are also 0, but note that the business will incur some fixed costs (FC) even when they have produced nothing at all. Because the FC do not depend on output, these costs are represented by a horizontal line. The total costs (TC) are found by adding the VC and the FC together. Total revenue (TR) will be dependent on the price the business chooses to set. In this example, the price has been set at £2 per unit. As sales rise, TR also rises. At an output level of Q1 on the diagram, the firm’s TR is the same as its TC – it is just covering its total costs and makes neither a profit nor a loss. At any output below Q1, however, the TC of production are higher than the TR received and the firm operates at a loss. If output is at any point above Q1 then the business will make a profit, but if output or sales are below this level then the business will make a loss.
The increase in Eurotunnel's debts as the construction costs mounted has been the main source of its problems. Interest payments on these debts have been a problem to Eurotunnel because they were simply not generating enough revenue to cover the variable costs. The construction costs are what are termed 'sunk costs' in this instance. Sunk costs are those costs that cannot be recouped. For some businesses, assets can be sold to realise cash to help with cash flow; this is possible if there are other uses for the assets - in other words there is a market for them.
Consider the case of a football club. Clubs can sell their assets (players, training facilities and even the land on which the ground is situated) to generate cash. With Eurotunnel, there is very little likelihood of anyone wanting to buy the tunnel - it only has one use! The costs that went into building it therefore become sunk costs.
The access charges that Eurotunnel passes on to the freight and passenger firms using the tunnel are the main source of revenue. The company has suggested that if it can discuss its pricing strategies with its stakeholders then it will be in a position to be able to increase its revenue. The company clearly believes that the price elasticity of demand for its service is relatively elastic, because it suggests that cutting freight prices by 50-60% would increase volumes by 300%. The fact that the Chief Executive feels that the infrastructure is being wasted suggests that he believes there is a lot more capacity in the system than currently being used, and this can be met by increases in freight traffic and passenger flows.
Even though Eurotunnel has managed to restructure its debts it can be seen as a business that will never break even. This is highly unusual, and it is the unique nature of the product and the associated, massive fixed costs that have been incurred that have led to this situation. Most firms who survive the initial development period will break even eventually. The prices that they charge determine how many sales they have to generate to do so, but it is important not to confuse the amount of sales with how long it will take to make those sales.
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