What is Break Even Time?
Break even time is the amount of time required for the discounted cash flows generated by a project to equal its initial cost. For example, if it takes two years for a project to generate $1,000 on a discounted basis to offset its $1,000 startup cost, the project’s break even time is two years. A shorter time period indicates that a project has less risk of failure, and so would be a better investment. A possible risk when relying on this method is over-optimism in making aggressive cash flow predictions.
Break-even time represents the amount of time it takes for an investment to make back its original cost. It’s calculated by using a prevent value table to measure the number of days the net cash flows from the investment will equal the original cost of the investment.
You might think of this as some kind of stock investment calculation, but it is used by businesses for any type of venture—not just investments in the market. Break-even time really a calculation of the acceptability of an investment in general. The investment could be in anything.
Take a manufacturer for example. Manufacturers don’t typically invest money into the stock market. Instead, they put all of their capital into asset and plant expansions. When looking at purchasing a new piece of equipment, management wants to know how long it will take for the company to make enough money off the machine to pay for the machine. Obviously, a lower BET represents a better purchase.
Retailers, on the other hand, don’t typically spend large amounts of money on equipment. In fact, most retailers don’t even own their own building. They usually rent a storefront in a plaza or mall. Retailers do however invest their money in leasehold improvements and store build outs to attract more customers. This is just as an important investment as a manufacturer purchasing new equipment. The retail management must know how long it will take the new store improvements to earn back their cost.
What Does Break Even Time Mean?
This break even calculation is important for cash flow purposes as well. Management must estimate the amount of cash coming in from the investment in order to make loan payments and other fees associated with the purchase.
Breakeven time measures the time to recover the investment in developing a new product from profits generated from the sale of the new product. This is represented graphically below.
This is an effective metric because it combines a number of factors:
- Initial Development Investment (non-recurring development cost) – as the amount of the investment is reduced through integrated product development practices, the breakeven time is reduced.
- Development Schedule (time-to-market) – as the development schedule or cycle time is reduced through integrated product development practices, the breakeven time is reduced.
- Product Capability/Satisfaction/Quality – as the capability of the product or its degree of satisfying customer needs increases, it will generate a higher sales volume, reducing the time to breakeven.
- Product Manufacturability/Design to Cost – As the manufacturabibility and affordability of a product increases, there will be a higher profit margin, reducing time to breakeven
Breakeven time requires a project costing system to accumulate the development costs including labor and a product revenue and cost accounting system to accumulate profits by product.