Question

What role does depreciation play in break-even analysis based on accounting flows? Based on cash flows? Which perspective is longer term in nature?

Short answer

Break even analysis is done by dividing the fixed cost with the contribution per share. Fixed cost includes the depreciation cost when the break even analysis is based on accounting flows. But when the company uses the cash flow basis for break even analysis, depreciation amount should be excluded from the fixed cost.

Accounting flows perspective is longer term in nature because we must consider problems of fixed asset replacement.

Step-by-step solution

Role of depreciation in break even analysis

Depreciation is considered as the fixed cost while computing the break even point based on accounting flows.

Role of depreciation while computing break even point based on cash flows

While computing the break even point based on the cash flows, depreciation shall be excluded from the fixed cost. Because, the depreciation of the company is a non-cash transaction. Cash flows perspective is not longer in nature because it does not consider the problem of fixed asset replacement. However, it is considered under accounting flows perspective.