Chapter 8

Breakeven Analysis for

Profit Planning

Breakeven Analysis
Breakeven analysis (cost-volume-profit
analysis): approach to profit planning
that requires derivation of various
relationships among revenue, fixed
costs, and variable costs in order to
determine units of production or volume
of sales dollars at which firm breaks
even (where total revenues equal
total of fixed and variable costs)

Assumptions of Breakeven
Analysis
1. Costs can be reasonably subdivided
into fixed and variable components.
2. All cost-volume-profit relationships
are linear.
3. Sales prices will not change with
changes in volume.

Assumptions of Breakeven
Anaylsis
1. Costs can be reasonably subdivided
into fixed and variable components.
Fixed costs (i.e. depreciation expenses,
salaries, rental expenses, etc.) and variable
costs (i.e. cost of direct labor and materials
used) can be easily identified in most cases.
Semivariable expenses can be
problematic, but can nonetheless be
separated into fixed and variable
components for analysis purposes.

Assumptions of Breakeven
Analysis
2. All cost-volume-profit
relationships are linear.
Assumption holds so long as analysis is
confined to reasonable range of
operations.
If level of operations are doubled,
relationship may be different.

Assumptions of Breakeven
Analysis
3. Sales prices will not change
with changes in volume.
Economic theory states that one would
normally expect price increase to be
accompanied by decrease in sales
volume and vice versa.
Assumption holds so long as analysis is
confined to reasonable range of prices.

Breakeven Applications
Four major applications:
1.
2.
3.
4.

New product decisions

Pricing decisions
Modernization or automation decisions.
Expansion decisions.

Breakeven Applications
1. New product decisions
Determine sales volume required for
firm (or individual product) to break
even, given expected sales and
expected costs

2. Pricing decisions
Study the effect of changing price and
volume relationships on total profits

Breakeven Analysis
3. Modernization or automation decisions
Analyze profit implications of a modernization or
automation program

In this case, firm substitutes fixed costs (i.e. capital equipment

costs) for variable costs (i.e. direct labor)

4. Expansion decisions
Study aggregate effect of general expansion in
production and sales

In this case, relationships between total dollar dales for all

products and total dollar costs for all products are examined in
order to indentify potential changes in these relationships

The Breakeven Technique

Simplified example
Peter Porters Porsche Plant is a
small business that assembles and
markets improved racing suspension for
Porsches

Fixed costs estimate: $1,650

Variable costs estimate: $350
Selling price per package:$500

The Breakeven Technique

At what point will new product break even?

Revenue = Fixed costs + Variable

costs
Requires determining quantity of items to be
produced and sold
Let X be equal to unknown breakeven quantity

$500X = $1,650 + $350X

$500X = total revenue produced by selling X items
$1,650 = total fixed costs
$350X = total variable costs incurred by producing X items

The Breakeven Technique

Solve the equation
$500X = $1,650 + $350X
$150X = $1,650
X = 11 units
Thus, 11 units is the breakeven
point for this product.
As a computational check, simply substitute
X=11 into the breakeven equation.

The Breakeven Technique

Operating Leverage
Contribution margin: difference between selling
price and variable cost; represents contribution made
by each unit sold toward covering fixed costs and
making profit
For Peter, contribution margin is $150.
This is key to breakeven problem.

Once enough units sold to cover fixed costs (11 units),

each unit then makes direct contribution to profits.
Once above breakeven point, relatively small
percentage increase in number of units sold will
produce relatively large percentage increase in profit.

The Breakeven Technique

Operating Leverage
If firm produces 12 units, it will then earn $150 in profit.

$500[12] - $350[12] - $1,650 = $150

Increase in production of 1 unit, or 8.3% (1/12=8.3%),
will result in profit of $300 (100% increase).
Additional increase of 1 unit will increase profits to
$450 (50% increase).
As production moves further and further above
breakeven point, operating leverage effect becomes
less dramatic in terms of percentage increase in profits
generated.

The Breakeven Technique

Operating Leverage
Implications of operating leverage concept:
As firm incurs higher levels of fixed costs due to use of
more capital equipment (becomes more capital
intensive), it normally incurs lower levels of variable
costs (becomes less labor intensive).
Once fixed costs are covered, any available contribution
margin will make direct contribution to profit.
If firm falls short of covering its fixed costs, loss will be
incurred.
The higher the degree of operating leverage, the
higher probability that loss may be incurred, and
the higher the risk.

The Breakeven Technique

Additional Breakeven Applications
1. Determine breakeven point in terms of
aggregate sales dollars for a multiproduct
operation.
Set up breakeven equation in terms of percentage
relationships.
Porter wants to expand his operation to full-time
business carrying full line of specialized racing
equipment.
Variable cost estimate: 70% of sales ($350/$500 = 70%)
Contribution margin per unit: 30% ($150/$500 = 30%)
Fixed costs estimate: $30,000

The Breakeven Technique

Additional Breakeven Applications
1. (continued)
Solve new equation:
Revenue (R) = Fixed costs + Variable costs
R = $30,000 +0.7R
0.3R = $30,000
R = $100,000
Thus, new operation will break even at
sales level of $100,000.

The Breakeven Technique

Additional Breakeven Applications

2. Determine sales dollars (or units)
required to earn given level of
profit
Porter is concerned with sales volume
required to earn $3,000 in profit

Add required profit to right-hand side of

original equation
X now equals number of units required to
earn $3,000 profit

The Breakeven Technique

Additional Breakeven Applications

2. (continued)
Revenue = Fixed costs + Variable costs +
Required profit

$500X = $1,650 + $350X + $3,000

$150X = $4,650
X = 31 units
Porter must sell 31 units, or $15,500
worth of suspensions ($500 x 31 =
$15,500).

The Breakeven Technique

Additional Breakeven Applications

3. Determine pricing decisions.
Porter wants to know what price he will
have to charge for given number of
orders and predetermined level of
profit.
If Porter sells 20 units, what price
should he charge to earn $3,000 in
profit?

The Breakeven Technique

Additional Breakeven Applications

3. (continued)
Solve in terms of selling price (X = sales price):
Revenue = Fixed costs + Variable costs + Required
profit
20X = $1,650 + $350 (20) + $3,000
20X = $1.650 + $7,000 + $3,000
20X = $11,650
X = $582.50
Selling price of $582.50 will yield required profit.

Breakeven Charts

See exhibit 8.1 for graphic

representation of breakeven problem
posed by Peter Porters Porsche Plant
1. Illustrates key assumptions of
breakeven analysis
Revenue and total cost are treated as simple
linear functions of number of units produced
and sold.
Profit or loss is difference between revenue and
total cost.
Breakeven point occurs where revenue equals
total cost.

Breakeven Charts

Exhibit 8.1 (continued)

2.

Provides simple visual interpretation of

effect of changing cost-volume-profit
relationships

Incurring additional fixed costs shifts horizontal fixed-cost

line upward, thus raising total-cost line parallel to itself and
causing breakeven point to rise.
Substitute additional fixed costs (i.e. additional
depreciation for improved capital equipment) for low levels
of variable cost (i.e. less direct labor and material waste):

Horizontal fixed-cost line moves upward, but total-cost line

becomes less steep due to lower levels of variable cost
Higher breakeven level and higher contribution margin
(revenue per unit less variable cost per unit)
At levels of operation sufficiently above breakeven point,
profits are much higher, while near or below breakeven, profits
are less or losses are greater.

Breakeven Charts

Exhibit 8.1 (continued)

2. (continued)

Porter buys additional capital equipment to produce

racing suspensions, causing annual fixed costs to rise
to $1,920.
Variable costs per unit decline to $340.
New contribution margin is $160 per unit
New breakeven point:

Revenue = Fixed costs + Variable costs

$500X = $1,920 + $340X
$160X = $1,920
X = 12 units

Breakeven Charts
See exhibit 8.2
At new level of operation, breakeven point is
one unit higher than old level.
At high levels of operation (30 units), profits under
new cost-volume-profit relationships are $2,880
(compared to $2,850 under old relationships)
At lower levels, (20 units), profits for new system
are $1,280 (compared to $1,350 for old system)
At loss levels (5 units), new relationships produce
loss of $1,120 (compared to $900 under old
relationships)
An increase in level of fixed costs must be
justified by expectation of level of operations
substantially in excess of breakeven level.

Breakeven Charts
Determine point at which new
relationships produce same profit as
old relationships.
R FC VC = R FC VC
$500X - $1,650 - $350X = $500X - $1,920 - $340X
$270 = $10X
X = 27 units
At 27 units of production, profits are same under
either alternative.
Under first alternative:
Profit = ($500) (27) - $1,650 ($350) (27) = $2,400
Under revised alternative:
Profit = ($500) (27) - $1,920 - ($340) (27) = $2,400

Breakeven Charts
See exhibit 8.3: profit as function of
units produced and sold is graphed for
each alternative
Above 27 units, second alternative will
produce larger profits than first
alternative.
Below 27 units, first alternative will
produce higher profits (in profit zone) or
lower losses (in loss zone) than second
alternative.

Nonlinear Breakeven
Analysis
Empirical studies of cost behavior over wide ranges of output
suggest that average variable cost per unit declines over some
range and then begins to increase.

See exhibit 8.4

Total cost function for wide ranges of
output looks like a curve
Total cost curve increases at decreasing rate over some
range and then begins to increase at increasing rate.

Revenue function more nearly resembles a

curve than a straight line over wide ranges
of output.
If sales volume continues to expand over very wide
range, sales price per unit must eventually decline in
order to achieve ever-increasing sales.

Nonlinear Breakeven
Analysis

Two key factors of exhibit 8.4

1. Two breakeven points in nonlinear case.

Lower breakeven point occurs at point where rising

revenue curve crosses rising total cost curve.
Upper breakeven point occurs at very high output
level where declining revenue curve crosses now rapidly
increasing total cost curve

2. Planning plant capacity

Maximum profit point represents point of maximum

separation of revenue and cost curves.
This is optimal production level: production at either
higher or lower levels of output will result in lower profits

Developing equation for curves is almost impossible,

but can be ignored for practical purposes.