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Greg Hiatt May 5, 2002

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 • Q = 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 $10 and it cost $5 to produce (UVC) and has fixed cost (FC) of $25,000 per year • How much will he need to sell to break-even? • 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 $1,000? $10Q - $5Q - $25,000 = $ 1,000 $5Q = $26,000 Q = 5,200

Algebraic approach:

(USP – UVC) x Q = FC + OI Q = FC + OI UMC Q = $25,000 + 0 $5 Q = 5,000

Contribution Margin equation

What quantity needs sold to make $1,000?

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

Graphical analysis:

Doll ars 70,000 Total Cost 60,000 Line 50,000 40,000 30,000 20,000 Total Revenue 10,000 Break-even point Line 0 1000 2000 3000 4000 5000 6000 Quantity

Graphical analysis:

Cont.

Dol lars 70,000 Total Cost 60,000 Line 50,000 40,000 30,000 20,000 Total Revenue 10,000 Break-even point Line 0 1000 2000 3000 4000 5000 6000 Quantity

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:
**

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

Comparative analysis Part 1

**Break-even analysis:
**

Part 1, Cont.

Machine A:

Machine B:

v = $3,000 $10 - $5 = 600 units 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

Doll ars 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.
**

Doll ars 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.

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