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
UVC FC

= Unit Selling Price

= Unit Variable costs = Fixed Costs

= Quantity of output units sold (and manufactured)

Defining Page:
Cont.
OI
TR TC

= Operating Income
= Total Revenue = 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:
(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:
Dollars 70,000 60,000 Total Cost 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 60,000 Total Cost 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:
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.