Solution Manual for Managerial Economics 6th

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Solution Manual for Managerial Economics 6th Edition for Keat

CHAPTER 8 APPENDIX B
BREAK-EVEN ANALYSIS (VOLUME-COST-PROFIT)

QUESTIONS

1. Volume-cost-profit (break-even) analysis ordinarily utilizes straight-line cost curves. Thus it

assumes the existence of constant average variable cost (and marginal cost), unlike the economist
who usually recognizes the existence of increasing and decreasing marginal and average variable
costs.

Since V-C-P analysis also utilizes a straight line revenue curve, it does not identify a maximum
profit. It shows profit increasing as a result of increases in quantity above the break-even point.

2. It analyzes short-run situations since it assumes the presence of fixed costs.

3. Fixed costs are those which are not affected by changes in quantity produced. The term constant
cost usually refers to average (unit) costs remaining the same as quantity changes. (However, total
cost changes as quantity changes.) In break-even analysis, average variable cost is usually
considered to be constant.

4. While economists usually assume the existence of increasing and decreasing marginal costs, using
constant costs over some relatively small output ranges is probably quite acceptable. Many
economic cost studies have shown that average cost can be constant over intervals. And even if
changing marginal (and average) costs are present, using a straight-line alternative over relatively
small quantity intervals will probably not detract a great deal from the analysis.

5. Assume the following: P=3

AVC = 2
TFC = 4,000

Break-even quantity: 4000/(3-2) = 4000

a. Break-even quantity will increase.

Assume P = 2.80
Break-even quantity: 4000/(2.80-2) = 5000

b. Break-even quantity will decrease.

Assume AVC = 1.40
Break-even quantity: 4000/(3-1.40) = 2500

c. Break-even quantity will decrease.

Assume TFC = 3000
Break-even quantity: 3000/(3-2) = 3000

6. Yes. The degree of operating leverage can be defined as a measure of business risk. A higher DOL
will result in greater fluctuations in profits for any given change in quantity. A lower DOL will
result in smaller profit fluctuations.

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 Break-Even Analysis 85

7. It probably could afford to have a plant with relatively high fixed costs. If higher fixed costs lead to
a higher DOL, then a company whose production is growing in a stable manner (i.e. without
significant fluctuations) will experience more rapid growth in profits than a company with a lower
DOL.

8. a. Add the required profit to the total fixed costs in the numerator of the formula.

b. Add the required unit profit to the average variable cost in the denominator of the formula.

9. No. The denominator of the DOL formula at break-even equals zero, and the ratio would have an
infinite value.

10. No, it is not. Corporate planning ordinarily requires detailed analysis of all component parts of the
corporation. Corporate planning also is based on long-run considerations such as returns to scale
and economies of scope.

11. V-C-P analysis can be used to make rather quick calculations showing the effect on profit of
relatively small changes in quantity from those shown in the detailed plan, or small changes in costs
and product prices (sensitivity analysis). It is also useful in making small corrections once the plan
has been established, and in arriving at some preliminary results when detailed data are not
available (for instance, in the planning of new products).

PROBLEMS

1. a. Q = 30000/(25-10) = 30000/15 = 2000

b. 2000 x 25 = 50000

c. TR (3000 x 25) 75,000

TFC 30,000
TVC (3000 x 10) 30,000
Profit 15,000

d. Q = 37500/(25-10) = 37500/15 = 2500

e. 2500 = (37500+15000)/(P-10)
= 52500/(P-10)
2500P - 25000 = 52500
2500P = 77500
P = 31

2. a. 5000 = 50000/(P-20)
5000P - 100000 = 50000
5000P = 150000
P = 30
b. 5000 = (50000+30000)/(P-20)
= 80000/(P-20)
5000P - 100000 = 80000
5000P = 180000
P = 36
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86 Break-Even Analysis

c. Q = 50000/(36-30)
= 50000/6
= 8333

3. Average variable cost:

Materials $30
Manufacturing labor (3x8) 24
Assembly labor (1x8) 8
Packing materials 3
Packing labor (6/3) 2
Shipping 10
Average variable cost $77

Total fixed cost $120,000

a. Q = 120000/(100-77) = 120000/23 = 5217

b. TR = 5217 x 100 = 521700

c. Quantity 2,000 4,000 6,000 8,000 10,000

TR 200,000 400,000 600,000 800,000 1,000,000
TFC 120,000 120,000 120,000 120,000 120,000
TVC 154,000 308,000 462,000 616,000 770,000
Profit -74,000 -28,000 18,000 64,000 110,000

4. Last Year Future

TR 250,000 200,000
TFC 100,000 100,000
TVC 100,000 100,000
Profit 50,000 0

No, they will no longer be profitable.

5. a. Q = 60000/(9-6) = 60000/3 = 20000

b. Q = (60000+15000)/(9-6) = 75000/3 = 25000

c. DOL at 20,000 units = undefined (denominator is zero)

25000 x 3 75000
DOL at 25,000 = ———————— = ——— = 5
(25000 x 3) - 60000 15000

30000 x 3 90000
d. DOL at 30,000 = ———————— = ——— = 3
(30000 x 3) - 60000 30000

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 Break-Even Analysis 87

6. Perfect Lawn Ideal Grass

a. Q = 200000/100 = 2000 Q = 400000/150 = 2667

b. (Qx100) - 200000 = (Qx150) - 400000

200000 = 50Q
4000 = Q

TR (4000 x 250) 1,000,000 (4000 x 250) 1,000,000

TFC 200,000 400,000
TVC (4000 x 150) 600,000 (4000 x 100) 400,000
Profit 200,000 200,000

c. 4000 x 100 4000 x 150

————————— = ————————— =
(4000 x 100) – 200000 (4000 x 150) - 400000

400000/200000 = 2 600000/200000 = 3

d. Ideal Grass will have the higher profit, since it has higher DOL.

TR (4500 x 250) 1,125,000 (4500 x 250) 1,125,000

TFC 200,000 400,000
TVC (4500 x 150) 675,000 (4500 x 100) 450,000
Profit 250,000 275,000

7. a. Q = 840000/(20-8) = 70000

b. (1) Q = 1200000/(20-5) = 80000

(2) 70000 = 1200000/(P - 5)

70000P - 350000 = 1200000
70000P = 1550000
P = 22.14

c. (1) (Qx12) - 840000 = (Qx14) - 1200000

360000 = 2Q
180000 = Q

Old Modernized
TR (180000 x 20) 3,600,000 (180000 x 19) 3,420,000
TFC 840,000 1,200,000
TVC (180000 x 8) 1,440,000 (180000 x 5) 900,000
Profit 1,320,000 1,320,000

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Solution Manual for Managerial Economics 6th Edition for Keat

88 Break-Even Analysis

(2)

180000x12 180000x14
————————— = ————————— =
(180000x12)-840000 (180000x14)-1200000

2160000 2520000
———— = 1.64 ———— = 1.91
1320000 1320000

(3) No. For the two plants to earn equal profits, sales would have to reach 180,000 units.
Below this quantity, the old plant is more profitable.

8. a. 1.5 = (8000)(P - AVC)/[(8000)(P - AVC) - 10000]

(1.5) (8000)(P - AVC) - (1.5)(10000) = (8000) (P - AVC)
(12000)(P - AVC) - 15000 = (8000)(P - AVC)
(4000)(P - AVC) = 15000
(P - AVC) = 3.75

We cannot ascertain price and average variable cost, but we know that contribution (P - AVC)
per unit is $3.75. Thus, profit is:

8000 x $3.75 $30,000

Less TFC 10,000
Profit $20,000
b. Q = TFC/(P - AVC)
= 10000/3.75
= 2666.67

9. a. 400000/(9 - 4) = 80000
b. (400000 + 100000)/(9 - 4) = 100000
c. (400000 + 100000)/(9 - 5) = 125000
d. (450000 + 100000)/(P - 4) = 9.50
e. (400000 + 50000)/(8 - AVC) = 3.50
f. (400000 + 100000)/(8 - 4) = 125000

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