Break-Even Analysis

Study of interrelationships among a firms sales, costs, and operating profit at various levels of output Break-even point is the Q where TR = TC (Q1 to Q2 on graph)
$s

TC TR

Profit

Q
Q2

Q1

Linear Break-Even Analysis

Over small enough range of output levels TR and TC may be linear, assuming Constant selling price (MR) Constant marginal cost (MC) Firm produces only one product No time lags between investment and resulting revenue stream

Graphic Solution Method

Draw a line through origin with a slope of P (product price) to represent TR function Draw a line that intersects vertical axis at level of fixed cost and has a slope of MC Intersection of TC and TR is break-even point TR $s TC
MC
1 unit Q

FC
P
1 unit Q

Break-even point

Algebraic Solution
Equate total revenue and total cost functions and solve for Q TR = P x Q TC = FC + (VC x Q) TR = TC P x QB = FC + VC x QB (P x QB) (VC x QB) = FC QB (P VC) = FC QB = FC/(P VC), or in terms of total dollar sales, PQ = (FxP)/(P-VC) = ((FxP)/P)/((P-VC)/P) = F/((P/P) (VC/P)) = F/(1-VC/P)

Related Concepts
Profit contribution = P VC
The amount per unit of sale contributed to fixed costs and profit

Target volume = (FC + Profit)/(P VC)

Output at which a targeted total profit would be achieved

Example 1 how many Christmas trees need to be sold

Wholesale price per tree is $8.00 Fixed cost is $30,000 Variable cost per tree is $5.00 Solution
Q(break-even) = F/(P VC) = $30,000/($8 - $5) = $30,000/$3 = 10,000 trees

Example 2 two production methods to accomplish same task

Method I : TC1 = FC1 + VC1 x Q Method II : TC2 = FC2 + VC2 x Q At break-even point:
FC1 + (VC1 x Q) = FC2 + (VC2 x Q) (VC1 x Q) (VC2 x Q) = FC2 FC1 Q x (VC1 VC2) = FC2 FC1 Q = (FC2 FC1)/(VC1 VC2)

Example 2 continued: bowsaw or chainsaw to cut Christmas trees

Bowsaw Fixed cost is $5.00 Variable cost is $0.40 per Chainsaw Fixed cost is $305 Variable cost is $0.10 per tree Solution Q(break-even) = ($305 - $5)/($0.40 - $0.10) = 300/.30 = 1,000 trees

Example 3: Optimal planting density

No. Trees per A @ 5 years 300 400 500 600 700 800 900 Yield in cords @ rotation 21.3 23.4 25.2 26.7 28.0 29.1 30.1 Total Revenue @$24/cord 511 562 605 641 672 698 722

Example 3: Continued
Fixed costs per acre:
Land . . . . . . . $300 Site prep . . . . 100 Annual . . . . 60 Set-up . . . . . 5 Total . . . . 465

Variable costs per 100 seedlings

Seedlings . . . . $ 5 Planting . . . . 20 Total . . . . 25

TC = 465 + 25 x (# trees per A/100)

Example 3: Continued
See Excel spreadsheet