Like the formula for Net Present Value (NPV) explored in an earlier post, break-even analysis is based on a time series of cash inflows and outflows. It is simply the time required for the discounted cash inflows to equal the discounted outflows. In other words, it is the point in time at which the NPV reaches zero.
Unlike NPV, break-even analysis does not represent return. It just measures how long it will take to earn back the investment. As such, it is more of a measure of risk. The shorter the time needed to break even, the lower the risk of the investment. Since change is the only constant in business, reducing the time for breaking even decreases the chance that market changes will invalidate the initial projections of cash inflows.
(In addition, break even analysis is used not only in project selection, but in an area of managerial accounting known as Cost-Volume-Profit Analysis explained at http://en.wikipedia.org/wiki/Break_even_analysis.)
As a simple metric, the break even period gets included in most business cases. But is it the best measure of risk? I’d say no, not the best, just the easiest. It is far better to analyze each of the project risks explicitly.
How long of a break-even period represents too much risk? When should an organization reject a project with a high ROI and NPV because the break-even period is too long? These are issues that should be addressed in an organization’s project selection guidelines.
How does your organization answer these questions?