Chapter 19

BREAK-EVEN ANALYSIS AND THE PAYBACK PERIOD

Teaching Guides for Problems in the Text

1. a. The table:

Quantity Total Variable Fixed Total Profits

Revenue Costs Costs Costs (Loss)

0 $0 $0 $6,000 $6,000 ($6,000)

500 4,250 1,600 6,000 7,600 (3,350)
1,000 8,500 3,200 6,000 9,200 (700)
1,500 12,750 4,800 6,000 10,800 1,950
2,000 17,000 6,400 6,000 12,400 4,600
2,500 21,250 8,000 6,000 14,000 7,250
3,000 25,500 9,600 6,000 15,600 9,900

b. The break-even level of output using the above table:

Quantity Total Variable Fixed Total Profits

Revenue Costs Costs Costs (Loss)

0 $0 $0 $6,000 $6,000 ($6,000)

500 4,250 1,600 6,000 7,600 (3,350)
1,000 8,500 3,200 6,000 9,200 (700)
1,132 9,622 3,622 6,000 9,622 ---
1,500 12,750 4,800 6,000 10,800 195
2,000 17,000 6,400 6,000 12,400 4,600

Confirmation of break-even level of output = FC/(P - V)

$6,000/($8.50 - 3.20) = 1,132 units

c. If fixed costs were $10,000 instead of $6,000, the fixed costs

and total costs schedules increase. There would be no change in the
total revenue schedule. The new break-even level of output is
Break-even level of output = FC/(P - V) =
$10,000/($8.50 - 3.20) = 1,887 units.

2. a. The break-even levels of output:

$3,000/($4 - 2.80) = 2,500
and $5,000/($4 - 2.40) = 3,125

b. Earnings = total revenues - total costs

Total revenue = $4(5,000) = $20,000
 Earnings under the two alternatives:
1. $20,000 - $3,000 - $2.80(5,000) = $3,000
2. $20,000 - $5,000 - $2.40(5,000) = $3,000

Sales of 5,000 units equates earnings. If output is less than 5,000

units, then the cost function with the lower fixed costs and higher
variable costs produces the higher profits (or smaller losses). If
output exceeds 5,000 units, then the scale of operation with higher
fixed costs and lower per unit costs will generate the higher earnings.

c. At sales of 2,000 and scale of operation with

TC = $3,000 + $2.80Q, then earnings are
$4(2,000) - $3,000 - $2.80(2,000) = ($600).

However, $1,500 of the expenses is non-cash depreciation, so the cash

flow generated by operations is
earnings ($600)
depreciation 1,500
$900

(Be certain to point out that a firm may operate at an accounting loss
but still generate positive cash flow.)

If the second scale of operations is used and TC = $5,000 + $2.4Q, the

earnings would be
earnings = $4(2,000) - $5,000 - $2.4(2,000) = ($1,800).

Cash flow would be

earnings ($1,800)
depreciation 2,500
$ 700

Either scale of operation generates positive cash flow.

d. If the firm selects the scale with more fixed costs (i.e.,
higher operating leverage), its earnings will be lower in year 1. This
could be justified on the grounds that the lower earnings are only
temporary.

If the level of sales only reaches 5,000 units, earnings are the same
for either scale of operation. The student should not conclude that the
scale of operation is unimportant in this case. The scale with the
higher fixed costs is riskier. The use of that scale increases risk.
Since earnings are the same under both alternatives, the scale with the
less risk (i.e., lower operating leverage) is to be preferred.
3. a. Break-even level of output:
$4,000/($2 - 1.50) = 8,000 units

Earnings: $2(9,000) - $4,000 - $1.50(9,000) = $500

b. Break-even level of output:

$6,000/($2 - .50) = 4,000 units

Earnings: $2(9,000) - $6,000 - $.50(9,000) = $7,500

Generally a substitution of fixed for variable costs increases the

level of output necessary to break even. However, that need not
necessarily always be the case, as this problem illustrates. The very
large decrease in per unit variable costs more than offsets the
increase in fixed costs with the result that the break-even level of
output declines.

4. a. Break-even level of output:

$125,000/($4.25 - $2.50) = 71,429 units

Earnings at sales of 100,000 units:

$4.25(100,000) - $125,000 - $2.50(100,000)
= $50,000

b. At fixed costs of $175,000, the break-even level of output is

$175,000/($4.25 - 2.50) = 100,000 units.

c. With variable costs of $2.25 per unit, the break-even level of

output is $175,000/($4.25 - 2.25) = 62,500 units.

d. If both variable and fixed costs change, the break-even level of

output is $175,000/($4.25 - 2.25) = 87,500 units.

e. If a substantial proportion of the costs is non-cash

depreciation expense, the firm may still generate sufficient cash to
meet its current obligations as they come due.

If $100,000 of the $125,000 fixed costs is depreciation, then only

$25,000 are fixed cash outlays. The firm's cash break-even level of
output is $25,000/($4.25 - 2.50) = 14,286 units.
5. Payback for A: 2.5 years (2 years and 6 months)

Payback for B: 2 years

Payback for C: 3 years

Based on the payback, investment C is inferior to investments A and B.

Selecting B, however, makes no sense, since investment C generates more
total cash flow ($12,000 versus $10,000 for A and $6,500 for B). There
has to be a better method for selecting long-term investments. You may
use this problem to set up the material on net present value and
internal rate of return.