Breakeven Analysis

WEEK 12 – ENGINEERING ECONOMY (KNS 4343)

Break Even Analysis
 is performed to determine the value of a variable or
parameter of a project or alternative that makes two
elements equal.

 is used to give answers to questions such as ‘what is the

minimum level of sales that ensure the company will not
experience loss’ or how much can sales be decreased and
company still continue to be profitable’

 is performed for two alternatives to determine when either

alternative is equally acceptable.
 Break Even Analysis
The following are examples of common factors for which breakeven analyses might
provide useful insights into the decision problem:

 Annual revenue and expenses. Solve for the annual revenue required to equal
(breakeven with) annual expenses. Breakeven annual expenses of an alternative
can also be determined in a pairwise comparison when revenues are identical for
both alternatives being considered.
 Rate of return. Solve for the rate of return on the increment of invested capital at
which two given alternatives are equally desirable.
 Minimum attractive rate of return. Solve for the interest rate value that would
result in indifference as to the preference for an alternative.
 Equipment life. Solve for the useful life required for an engineering project to be
economically justified.
 Capacity utilization. Solve for the hours of utilization per year, for example, at
which an alternative is justified or at which two alternatives are equally desirable.
Break Even Analysis
 Breakeven analysis finds the value of a parameter that
makes two elements equal.

 The breakeven point QBE is determined from mathematical

relations, e.g., product revenue and costs or materials
supply and demand or other parameters that involve the
parameter Q .

 Breakeven analysis is fundamental to evaluations such as

make-buy decisions.

 The unit of the parameter Q may vary widely: units per

year, cost per kilogram, hours per month, percentage of full
plant capacity, etc.
Break Even Analysis
Linear and nonlinear revenue and cost relations
 Figure presents different shapes of a revenue
relation identified as R .

 A linear revenue relation is commonly assumed,

but a nonlinear relation is often more realistic.

 It can model an increasing per unit revenue with

larger volumes (curve 1) or a decreasing per-
unit revenue that usually prevails at higher
quantities (curve 2).
Break Even Analysis
Linear and nonlinear revenue and cost relations

• Costs (C), which may be linear or nonlinear, usually

include two components—fixed and variable.

• Fixed costs (FC). These include costs such as

buildings, insurance, fixed overhead, some
minimum level of labor, equipment capital recovery,
and information systems.

• Variable costs (VC). These include costs such as

direct labor, materials, indirect costs, contractors,
marketing, advertisement, and warranty.
Break Even Analysis
Linear and nonlinear revenue and cost relations
Fixed-cost component is
essentially constant for all values
of the variable, so it does not vary
for a large range of operating
parameters, such as production
level or workforce size. Even if no
units are produced, fixed costs are
incurred at some threshold level.
Variable costs change with
production level, workforce size,
and other parameters. It is usually
possible to decrease variable
costs through better product
design, manufacturing efficiency,
improved quality and safety, and
higher sales volume.
Break Even Analysis
Linear and nonlinear revenue and cost relations
When FC and VC are
added, they form the total
cost relation TC.

Figure (b) illustrates the TC

relation for linear fixed and
variable costs.

Figure (c ) shows a general

TC curve for a nonlinear VC
in which unit variable costs
decrease as the quantity
level rises.
 Break Even Analysis
Linear and nonlinear revenue and cost relations

At a specific but unknown value Q of the decision

variable, the revenue R and total cost TC relations
will intersect to identify the breakeven point QBE
(Figure). If Q > QBE, there is a predictable profit; but
if Q < QBE , there is a loss.

For linear models of R and VC, the greater the

quantity, the larger the profit. Profit is calculated as :

[Eq. BE.1]
Break Even Analysis
Linear and nonlinear revenue and cost relations
A relation for the breakeven point may be Solve for the breakeven quantity Q = QBE
derived when revenue and total cost are for linear R and TC functions.
linear functions of quantity Q by setting the
relations for R and TC equal to each other,
indicating a profit of zero.
[Eq. BE.2]

[Eq. BE.2-1]

[Eq. BE.2-2]
Break Even Analysis
Linear and nonlinear revenue and cost relations
The breakeven graph is an important management
tool because it is easy to understand and may be
used in decision making in a variety of ways. For
example, if the variable cost per unit is reduced, then
the TC line has a smaller slope (Figure) and the
breakeven point will decrease.

This is an advantage because the smaller the value

of QBE , the greater the profit for a given amount of
revenue.

Figure: Effect on the breakeven point

when the variable cost per unit is reduced
Break Even Analysis
Linear and nonlinear revenue and cost relations
If nonlinear R or TC models are used, there may be more
than one breakeven point. Figure presents this situation
for two breakeven points. The maximum profit occurs at
Q P between the two breakeven points where the distance
between the R and TC relations is greatest.

Of course, no static R and TC relations—linear or

nonlinear—are able to estimate exactly the revenue
and cost amounts over an extended period of time. But
the breakeven point is an excellent target for planning
purposes.

Figure: Breakeven points and maximum

profit point for a nonlinear analysis.
Break Even Analysis
Effects of FC, VC, and P(r) on break-even output
Direction of Break-even
Variable
Change Output
Total Fixed Cost Up Up
(e.g., cost of equipment) Down Down
Average Variable Cost Up Up
(e.g., cost of material) Down Down
Product Price Up Down
(P, r) Down Up
 Break Even Analysis
EXAMPLE
1 Calculate the break-even output for 2 Suppose TFC = RM10,000, P = RM5,
TFC = RM20,000, P = RM7, and AVC = RM2. What is the output
AVC = RM5 necessary to earn RM5000 total profit?
Answer: Answer:

[Eq. BE.2-2]

[Eq. BE.2-1]
Break Even Analysis
EXAMPLE
Indira Industries is a major producer of diverter dampers used in the gas turbine power
industry to divert gas exhausts from the turbine to a side stack, thus reducing the noise
to acceptable levels for human environments. Normal production level is 60 diverter
systems per month, but due to significantly improved economic conditions in Asia,
production is at 72 per month. The following information is available.
◦ Fixed costs FC = $2.4 million per month
◦ Variable cost per unit v = $35,000
◦ Revenue per unit r = $75,000
a) How does the increased production level of 72 units per month compare with the
current breakeven point?
b) What is the current profit level per month for the facility?
 Break Even Analysis
Solution
(a) Use Equation [BE.2] to determine the breakeven
number of units. All dollar amounts are in $1000
units.

The breakeven value is 60 damper units. The

increased production level of 72 units is above
the breakeven value.
 Break Even Analysis
Solution
(b) To estimate profit (in $1000 units) at Q 72 units
per month, use Equation [BE.1]

There is a profit of $480,000 per month currently

Break Even Analysis
PAUSE and SOLVE
The average variable cost is constant at $5.00 per unit. The
firm is selling 1000 units a week. Average fixed cost is also $5
per unit. The market price for the product is $12.00 per unit.
a) Calculate total profit.
b) Derive an equation for total cost.
c) Calculate the break-even level of output.
d) If the firm sets a target of $3400 as their weekly profit, how
many units of output should it sell?
Break Even Analysis
TAKE HOME EXERCISES WEEK 12
1 Easy-Barrows, Inc., produces wheelbarrows. Its costs have been analyzed as follows:

VARIABLE COST FIXED COSTS

Materials $30/unit Overhead labor $50,000/year
Manufacturing labor 3 hours/unit ($8/hour) Utilities $5,000/year
Assembly labor 1 hour/unit ($8/hour) Plant operation $65,000/year
Packing materials $3/unit SELLING PRICE $100/unit
Packing labor 20 minutes/unit ($6/hour)
Shipping cost $10/unit

Calculate the break-even quantity!

Break Even Analysis
TAKE HOME EXERCISES WEEK 12
2 Two companies, Lawnman Inc. and Tauro Co., are competing in the manufacture and sale of a
new type of kryptonite-powered lawnmowers. Lawnman has a somewhat older plant and requires
a variable cost of $150 per lawnmower; its fixed costs are $200,000 per year. Tauro's plant is
more automated and thus has lower unit variable costs of $100; its fixed cost is $400,000. Since
the two companies are close competitors, they both sell their product at $250 per unit.
Lawnman Inc. Tauro Co.
TFC ($/year) $200,000 $400,000
TFC ($/year) $150 $100
Price $250 $250

a. What is the break-even quantity for each?

b. At which quantity would the two companies have equal profits?
Break Even Analysis
TAKE HOME EXERCISES WEEK 12
3 Smith Toaster Co. is contemplating a modernization of its antiquated plant. It now sells
its toasters for $20 each; the variable cost per unit is $8, and fixed costs are $840,000
per year
a) Calculate the break-even quantity.
b) If the proposed modernization is carried out, the new plant would have fixed costs of
$1,200,000 per year, but its variable costs would decrease to $5 per unit.
(1) What will be the break-even point now?
(2) if the company wanted to break even at the same quantity as with the old plant,
what price would it have to charge for a toaster?
 Break Even Analysis
TAKE HOME EXERCISES WEEK 12
4 Consider a firm which has a TFC of $200 and an AVC of $10
per unit. The expected sales at three alternative prices are:

P Q
Alternative 1 20 25
Alternative 2 15 60
Alternative 3 12.5 110

Which of these three prices would bring it the highest profit?

 Break Even Analysis
TAKE HOME EXERCISES WEEK 12
5 ABC Company is contemplating manufacturing a product which can be sold for $10 per unit on
the market. It knows of two production processes, between which it has to choose one, and only
one. The following data have been collected for Q = 150,000 units.
Production Production
Process 1 Process 2
TVC 800,000 950,000
TFC 400,000 250,000
a) Calculate the break-even point for each process.
b) Which process should be used if there was a high probability of exceeding sales of
150,000 units? Why?
c) Which process should be used if there was a high probability of selling considerably
less than 150,000 units? Why?
Thank You