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Application of Break even analysis for Operations

Management

A. Ramesh Ph.D
Department of Management Studies
Indian institute of Technology Roorkee
Application 1:
Make or Buy decision
Breakeven Analysis
Cost
Used to determine
volume needed to
cover total costs
Often first step in
product development
process
Assumes linear costs
Volume

F ix e d c o s t
B reakeven
( u n it p r ic e ) ( u n it v a r ia b le c o s t )
Introduction to Breakeven Analysis

Breakeven Analysis in the context of Production planning


addresses the decision of whether to make or buy a product.
Making the product involves two cost elements:
Fixed costs such as machine renting cost and operation expenses
Variable costs such as raw material cost
Buying the product involves only one cost element, the
selling price. However, the price may either be constant or
variable based on the quantity.
Break-Een Analysis
Widely used to analyze and compare decision
alternatives
Can be displayed either algebraically or graphically
Disadvantages:
Cannot incorporate uncertainty
Costs assumed over entire range of values
Does not take into account time value of money
Linear Breakeven Analysis
Assumptions: (1) Price is constant (p); (2) We have fixed costs; (3)
We have constant variable cost.
Buy Cost (BC) = pQ
Cost Making is better

Make Cost (MC) = FC + vQ

Buying is better

Variable cost: vQ

Fixed Cost: FC

Savings : S = BC MC = pQ FC vQ
Breakeven: S = 0, pQ = FC + vQ

Quantity (Q)
Q
Linear Breakeven Analysis

A particular product sells for a price of $70. If the


fixed cost are $800/month and the variable cost
per unit is $30/unit, determine the breakeven
quantity.
Application 2: Selection
of Process Alternatives
Cost Functions of Processing Alternatives

Annual Cost of Production ($000)

hop u f.
S Ma n
Job lu l ar
C el

e mb ly L ine
ss
2,000 Autom. A
Automated
1,500 Assembly Line
Preferred
Cellular
1,000
Manufacturing
Job
Preferred Units
500 Shop
Preferred Produced
Per Year
100,000 250,000
Cost Functions of Processing Alternatives

Example-1
Three production processes (A, B, and C) have
the following cost structure:
Fixed Cost Variable Cost
Process Per Year Per unit
A $120,000 $3.00
B 90,000 4.00
C 80,000 4.50
What is the most economical process for a volume
of 8,000 units per year?
Cost Functions of Processing Alternatives

Example

TC = FC + v(Q)
A: TC = 120,000 + 3.00(8,000) = $144,000 per year
B: TC = 90,000 + 4.00(8,000) = $122,000 per year
C: TC = 80,000 + 4.50(8,000) = $116,000 per year
The most economical process at 8,000 units is
Process C, with the lowest annual cost.
Break-Even Analysis

Example
Break-Even Points of Processes A, B, and C,
assuming a $6.95 selling price per unit
Q = FC / (p-v)
A: Q = 120,000 / (6.95 - 3.00) = 30,380 units
B: Q = 90,000 / (6.95 - 4.00) = 30,509 units
C: Q = 80,000 / (6.95 - 4.50) = 32,654 units
Process A has the lowest break-even point.
Breakeven Example-2
A firm is considering marketing a new toothbrush. The firm
expects to sell each toothbrush for $ 2.10. The per brush cost
of material, labor and overhead equals $.1.45. The required
investment in plant and equipment is Rs. 50,000.

How many brushes must 5 0 ,0 0 0


be sold for the firm to 7 6 ,9 2 3
breakeven? 2 .1 0 1 . 4 5

If only 65,000 brushes are


6 5 , 0 0 0 ( 2 .1 0 ) 5 0 , 0 0 0 6 5 , 0 0 0 ( V C ) expected to sell, what must
the variable costs be in
V C 1 .3 3 1 order to allow the firm to
breakeven?
Break-even Analysis Example

Dum-Dum Service Station is looking to invest in a new fully


automated car wash. They have collected the following
information on three different models.
Initial Variable
Investment Cost (car)
a) VacuClean System 250,000 1.50
b) Wash n Scrub Model III 400,000 1.20
c) DynoClean 550,000 0.95
2 5 0 , 0 0 0 1 .5 x 4 0 0 , 0 0 0 1 . 2 x
a&b
x 5 0 0 ,0 0 0
4 0 0 ,0 0 0 1 .2 x 5 5 0 , 0 0 0 .9 5 x
b&c
x 6 0 0 ,0 0 0
2 5 0 , 0 0 0 1 .5 x 5 5 0 , 0 0 0 . 9 5 x
a&c
x 5 4 5 ,4 5 4
Total Cost
Car Wash Break-even Analysis Continued

o C le a n
Dyn
550,000 Sc rub
hn
Was
400,000 e a n
Cl
250,000 acu
V
0 545,454

600,000
500,000

Volume
Car Wash Break-even Analysis Continued
If we were able to charge Rs.1.75 for a car wash, at
what volumes would we breakeven?
Initial Variable
Investment Cost (car)
a) VacuClean System 250,000 1.50
b) Wash n Scrub Model III 400,000 1.20
c) DynoClean 550,000 0.95

a) 250,000/1.75-1.50=1,000,000
b) 400,000/1.75-1.20= 727,272
c) 550,000/1.75-0.95= 687,500

Note that the best profit-making process decision is


Dynoclean and only if demand is greater than 687,500