Break-Even Analysis

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

= Unit Selling Price

UVC

= Unit Variable costs

FC

= Fixed Costs

= Quantity of output units

sold (and manufactured)

Defining Page:
Cont.
OI

= Operating Income

TR

= Total Revenue

TC

= Total Cost

USP

= 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:

Contribution Margin equation

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

What quantity needs sold to make $1,000?

Q
Q

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

Graphical analysis:
Dollars
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.

Dollars
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:

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
=
Machine B
FC + VC
=
FC + VC
$3,000 + $5 Q
= $8,000 + $2Q
$3Q
= $5,000
Q
= 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
=
Machine B
FC + VC
=
FC + VC
$5,000 + $5 Q
= $15,000 + $1Q
$4Q
= $10,000
Q
= 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.