Break-Even Analysis

Defined:
Break-even analysis examines the cost tradeoffs associated with demand volume.

Overview:

Break-Even Analysis
Benefits Defining Page Getting Started Break-even Analysis Break-even point Comparing variables Algebraic Approach Graphical Approach

Benefits and Uses:

The evaluation to determine necessary levels of service or production to avoid loss.

Comparing different variables to determine best case scenario.

Defining Page:
USP
UVC FC

= Unit Selling Price

= Unit Variable costs = Fixed Costs

= Quantity of output units sold (and manufactured)

Defining Page:
Cont.
OI TR TC USP = Operating Income = Total Revenue = Total Cost = Unit Selling Price

Getting Started:
Determination of which equation method to use: Basic equation Contribution margin equation Graphical display

Break-even analysis:
Break-even point
John sells a product for Rs10 and it cost Rs5 to produce (UVC) and has fixed cost (FC) of Rs25,000 per year How much will he need to sell to breakeven? How much will he need to sell to make $1000?

Algebraic approach:
Basic equation
Revenues Variable cost Fixed cost = OI

(USP x Q) (UVC x Q) FC = OI 10Q - 5Q 25,000 = 0.00 5Q = 25,000 Q = 5,000 What quantity demand will earn Rs1,000? 10Q - 5Q - 25,000 = 1,000 5Q = 26,000 Q = 5,200

Algebraic approach:

Contribution Margin equation

(USP UVC) x Q = FC + OI Q = FC + OI usp-uv
c Q = 25,000 + 0 5 Q = 5,000
What quantity needs sold to make 1,000?

Q = 25,000 + 1,000 5 Q = 5,200

Graphical analysis:
Rs 70,000 60,000 50,000 40,000 30,000 20,000 10,000
point

Total Cost Line

0 1000 2000 3000 4000 5000 6000 Quantity

Total Revenue Line

Break-even

Graphical analysis:
Cont.
Dollars 70,000 60,000 50,000 40,000 30,000 20,000 10,000
point

Total Cost Line

0 1000 2000 3000 4000 5000 6000 Quantity

Total Revenue Line

Break-even

Scenario 1:

Break-even Analysis Simplified

When total revenue is equal to total cost the process is at the break-even point. TC = TR

Break-even Analysis:

Comparing different variables

Company XYZ has to choose between two machines to purchase. The selling price is $10 per unit. Machine A: annual cost of $3000 with per unit cost (VC) of $5. Machine B: annual cost of $8000 with per unit cost (VC) of $2.

Break-even analysis:

Comparative analysis Part 1

Determine break-even point for Machine A and Machine B. Where: V = FC SP - VC

Break-even analysis:
Part 1, Cont.
Machine A: v = $3,000 $10 - $5 = 600 units Machine B: v = $8,000 $10 - $2 = 1000 units

Part 1: Comparison
Compare the two results to determine minimum quantity sold. Part 1 shows: 600 units are the minimum. Demand of 600 you would choose Machine A.

Part 2: Comparison
Finding point of indifference between Machine A and Machine B will give the quantity demand required to select Machine B over Machine A.
Machine A FC + VC = $3,000 + $5 Q $3Q Q = Machine B FC + VC = $8,000 + $2Q = $5,000 = 1667

Part 2: Comparison
Cont.
Knowing the point of indifference we will choose: Machine A when quantity demanded is between 600 and 1667. Machine B when quantity demanded exceeds 1667.

Part 2: Comparison
Graphically displayed
Dollars 21,000 18,000 Machine A 15,000 12,000 9,000 Machine B 6,000 3,000 0 500 1000 1500 2000 2500 3000 Quantity

Part 2: Comparison

Graphically displayed Cont.

Dollars 21,000 18,000 Machine A 15,000 12,000 9,000 Machine B 6,000 3,000 Point of indifference 0 500 1000 1500 2000 2500 3000 Quantity

Exercise 1:
Company ABC sell widgets for $30 a unit.
Their fixed cost is$100,000 Their variable cost is $10 per unit.

What is the break-even point using the basic algebraic approach?

Exercise 1:
Answer
Revenues Variable cost - Fixed cost = OI

(USP x Q) (UVC x Q) FC $30Q - $10Q $100,00 $20Q Q

= = = =

OI $ 0.00 $100,000 5,000

Exercise 2:
Company DEF has a choice of two machines to purchase. They both make the same product which sells for $10. Machine A has FC of $5,000 and a per unit cost of $5. Machine B has FC of $15,000 and a per unit cost of $1.

Under what conditions would you select Machine A?

Exercise 2:
Answer
Step 1: Break-even analysis on both options. Machine A: v = $5,000 $10 - $5 = 1000 units Machine B: v = $15,000 $10 - $1 = 1667 units

Exercise 2:
Answer Cont.
Machine A FC + VC = $5,000 + $5 Q $4Q Q = Machine B FC + VC = $15,000 + $1Q = $10,000 = 2500

Machine A should be purchased if expected demand is between 1000 and 2500 units per year.

Summary:
Break-even analysis can be an effective tool in determining the cost effectiveness of a product.

Required quantities to avoid loss.

Use as a comparison tool for making a decision.

Bibliography:
Russel, Roberta S., and Bernard W. Taylor III. Operations Management. Upper Saddle River, NJ: Pentice-Hall, 2000. Horngren, Charles T., George Foster, and Srikant M. Datar. Cost Account. 10th ed. Upper Saddle River, NJ: Pentice-Hall, 2000.