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Slides to accompany Blank and Tarquin 2014, McGraw-Hill Education

Basics of Engineering Economy, 2nd ed. 8-1 All rights reserved


Chapter 8 Breakeven, Payback

PURPOSES TOPICS
! Breakeven value for
Determine a single project
parameters value to ! Breakeven between two
breakeven or payback alternatives
! Payback period for i = 0%
for one or more and i > 0%.
alternatives

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8-4 All rights reserved
Sec 8.1 Breakeven for Single Project
DEFINITION
Breakeven point is the value of a parameter or decision
variable that makes two relations equal
Breakeven is point of indifference between two projects
Breakeven analysis can be performed considering time
value of money (i > 0%) or without it (i = 0%)

Example breakeven points


! Sales volume necessary to just cover costs
! Price of gas to consumers to just recover drilling,
processing and delivery costs
! Interest rate such that two alternatives cash flows are
equivalent

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Sec 8.1 Breakeven for Single Project
Two relations equated may be
PWA = PWB or Revenue = Cost
DIFFERENT REVENUE CURVES

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Sec 8.1 Breakeven for Single Project
COST ELEMENTS
Fixed costs (FC) - Costs incurred regardless
of volume level to stay in business
Examples are:
Building costs - Minimum labor costs
Insurance - Utilities
Capital recovery of equipment

Variable costs (VC) Costs that vary with level


of activity
Examples are: Costs can
Materials costs - Labor costs be
Advertisement - Warranty linear or
Legal costs - Subcontractor costs nonlinear
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Sec 8.1 Breakeven for Single Project
Sample cost curves for TC = FC + VC
Q = quantity in units

Linear FC and VC Linear FC; VC with


decreasing unit cost
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Sec 8.1 Breakeven for Single Project

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Sec 8.1 Breakeven for Single Project
Profit = R - TC
Breakeven at P = 0
R = TC
R = FC + VC
rQ = FC + vQ
Solve for Q to obtain
breakeven point

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Sec 8.1 Breakeven for Single Project
Linear Breakeven Analysis Variables and Equations
Linear variable cost: VC = vQ
where v = unit cost, $/unit
Q = quantity, units
Breakeven quantity or point: Q = QBE

Linear revenue: R = rQ
where r = unit revenue, $/unit

Profit when Q > QBE: P = R TC


= rQ (FC + vQ)
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Sec 8.1 Breakeven for Single Project
Example 8.1:

Nicholea Water LLC dispenses water via vending


machines. Fixed cost per site is $900, each gallon
costs 18 to purify, sells for 30.

- Determine monthly sales volume for breakeven

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Sec 8.1 Breakeven Quantity - Example
Water vending machine: FC = $900 per month per site
r = 30 per gallon v = 18 per gallon

Must sell 7,500 gallons per month per site to breakeven


Selling more means a profit is realized

What if the variable cost per unit is reduced through


improved efficiency methods? (see graph on next slide)

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Sec 8.1 Breakeven Quantity

As v decreases,
VC = vQ has a
lower slope

Therefore, TC line
has a lower slope
Breakeven point
decreases
Result: Larger profit
for same amount of
revenue

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Sec 8.1 Example - Breakeven Quantity
Assume v is lowered from 18 to 15 per gallon
Determine profit at sales of Q = 8,000 gallons/site

QBE = FC/(r-v) Profit = (r-v)Q FC


= 900/(0.30-v) = (0.30-v)8,000 - 900

v, /gallon
0.18 0.15
QBE 7,500 6,000
Profit $60 $300
Q=8,000
Big increase in profit for reduced variable cost
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Sec 8.1 Breakeven for Single Project
Additional considerations
" Breakeven on a per unit basis:
#Has the same QBE formula
#Average cost per unit is Cu

Cu = FC/Q + v

" Nonlinear R and/or TC relations:


# May have more than 1 breakeven points and there
may be a profit range
# For 2 breakeven points, maximum profit occurs
where separation between R and TC curves is largest
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Sec 8.1 Breakeven for Single Project

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Sec 8.1 Breakeven for Single Project
For PW, AW and FW relations when a (one) parameter
estimate is not reliable or known

Given P, F, A, i, n

If all these parameters above are reliably estimated


except one, the unknown parameter can be
calculated or approximated as a breakeven value

To determine it, set PW, FW, or AW equivalency


relation = 0 and solve for the unknown parameter

This approach was used to find ROR (Sec 6.2); the i*


value is a breakeven value
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Sec 8.1 Breakeven for Single Project
Example:

A professional musician pays $20,000 for a musical


instrument that has 10% salvage value after 5 years.
His costs are $100 per day, and he charges $300 per
day for an appearance.
Find the number of gigs he must perform in a year to
breakeven.

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Sec 8.1 - Example-Breakeven Using AW
P = $-20,000 S = 10% of P = $2,000 n = 5 years
r = $300 per event FC = $-100 per event X=?
Find X, number of events per year to breakeven at i = 5%

Solution: Set AW relation = 0 and solve for X

0 = -20,000(A/P,5%,5) + 2,000(A/F,5%,5) 100X + 300X


200X = 4257.46
X = 21.3 events per year

A total of 22 events per year will recover


investment and costs plus slightly more
than a 5% rate of return
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Sec 8.2 - Breakeven Between 2 Alternatives
$ Breakeven point is one of indifference between
alternatives
$ Involves finding value of parameter common to the
two relations
$ Can use:
# PW or AW relation at i%, or
# TC relations without time value of money
considered

Solution
Set relations equal and
solve for parameter value

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Sec 8.2 - Breakeven Between 2 Alternatives
Selection guideline
Compare the common
parameter expected
level to its breakeven
quantity
! If expected level is <
breakeven, select higher
variable cost (larger
slope on TC line)
(Alternative 1 in graph)
! If expected level is >
breakeven, select lower
variable cost (smaller
slope on TC line)
(Alternative 2 in graph)
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Example:

Read Example 8.2 page 214

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Sec 8.2-Two Alternative Breakeven-Example 1

Alternative A M
P, $ -23,000 -8,000
S, $ 4,000 0
Life, years 10 5
M&O, $/year -3,500 -1,500
Labor rate $/hr 24 12
People 1 3
Output, tons/hr 8 6
cont
Find breakeven in tons per year (x) to justify
the higher initial cost alternative (A) at i = 10%

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Sec 8.2-Two Alternative Breakeven-Example 1
Solution approach:
1. Determine VC expression for both A and M using
the common variable x = tons per year
2. Set up AW relations for both alternatives
3. Equate AW relations and solve for x
4. Determine when A or M is selected

A: variable cost expression

M: variable cost expression

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Sec 8.2-Two Alternative Breakeven-Example 1

A: AW relation

M: AW relation

Equate AWA = AWM and solve for x


-6,992 3x = -3,610 - 6x
x = 1127 tons per year cont

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Sec 8.2-Two Alternative Breakeven-Example 1

Select smaller variable


cost if tonnage
exceeds 1127 per year
A has smaller variable
cost (3x)
Conclusion: Choose A
if more than 1127
tons per year
Spreadsheet plot of AW
curves shows this
graphically
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Sec 8.2-Two Alternative Breakeven-Example 2
Buy alternative: 60 per unit

Make alternative A B
P, $ -18,000 -12,000
S, $ 2,000 - 500
Life, years 6 4
AOC, $/year -6,000 -5,000
Overhaul, $ -3,000 each 3 years
Labor rate $/hr 12.50
People 4
Output, units/8-hr 1000 cont

Select make or buy at 125,000 units/year and MARR = 15%


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Sec 8.2-Two Alternative Breakeven-Example 2
VC AND AW FOR MAKE ALTERNATIVE
Breakeven: x = number of units per year

Variable cost relation:

AWA + AWB VC = -18,000(A/P,15%,6)+2000(A/F,15%,6)


-6000 -3000(P/F,15%,3)(A/P,15%,6)
-12,000(A/P,15%,4)-500(A/F,15%,4)-5000
-0.4x
cont
Equate AW relations for buy and make; solve for x
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Sec 8.2-Two Alternative Breakeven-Example 2
-0.60x = AWA+ AWB - VC
-0.20x = -20,352
x = 101,762 units per year

At level of 125,000 > 101,762 breakeven


quantity
Select lower variable cost alternative (0.4x and 0.6x)

Select to make inhouse

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Sec 8.5 Payback (Payout) Period
Purpose: Determine time (in years, usually) to
recover the first cost or initial investment, P
Payback period is termed np

There are some important cautions to observe


when using this technique
Discussed throughout slides

Two types of payback analysis


# i = 0% no return expected; recover P only
# i > 0% recover P plus return of i%
(also called discounted payback)

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Sec 8.5 Discounted Payback Period
! At i% > 0, find np such that annual net cash flow (NCF)
estimates just offset P

where NCF = cash outflows cash inflows

! If NCF forms a uniform series, find np using

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Sec 8.5 No-return Payback Analysis
! Determines np when i = 0%; no return expected

! If NCF forms a uniform series, np is simply

! Remember the cautions on using payback

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Example 8.7 page 224
J&J Health allocated $18 million to develop a new
treatment product.

Results expected to impact cashflow 6 years from now,


at an average level of $6 million per year.

- Determine pay back periods for both no-return and


at i=10%.

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Sec 8.5 Example: No-return Payback
A = $6M

0 1 2 3 4 5 6 7 8 np
P = $18M x

Find payback using PW at 0% (no return)


0 = -18M +6M(x)
x=3
np = 5 + 3 = 8 years

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Sec 8.5 Example: Discounted Payback
A = $6M

0 1 2 3 4 5 6 7 8
np
x
P = $18M

Find payback using PW at 10% return


0 = -18M +6M(P/A,10%,x)(P/F,10%,5)
x = 6.9
np = 5 + 6.9 = 12 years (approx)
Requiring a 10% return increases payback
by 50% from 8 to 12 years 2014, McGraw-Hill Education
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