BreakBreak-Even Analysis

Srinivas Gumparthi

Defined:
BreakBreak-even analysis examines the cost tradeoffs associated with demand volume.

Overview:
BreakBreak-Even Analysis
‡ ‡ ‡ ‡ Benefits Defining Page Getting Started Break-even Analysis Break² Break-even point Break² Comparing variables ‡ Algebraic Approach ‡ Graphical Approach

Benefits and Uses:
‡ The evaluation to determine necessary levels of service or production to avoid loss. ‡ Comparing different variables to determine best case scenario.

Defining Page:
‡ USP ‡ UVC ‡ FC ‡ Q = Unit Selling Price = Unit Variable costs = Fixed Costs = Quantity of output units sold (and manufactured)

Defining Page:
Cont.
‡ OI ‡ TR ‡ TC ‡ USP = Operating Income = Total Revenue = Total Cost = Unit Selling Price

Getting Started:
‡ Determination of which equation method to use: ² Basic equation ² Contribution margin equation ² Graphical display

BreakBreak-even analysis:
BreakBreak-even point
‡ John sells a product for $10 and it cost $5 to produce (UVC) and has fixed cost (FC) of $25,000 per year ‡ How much will he need to sell to breakbreak-even? ‡ How much will he need to sell to make $1000?

Algebraic approach:
Basic equation
Revenues ² Variable cost ² Fixed cost = OI

(USP x Q) ² (UVC x Q) ² FC = OI $10Q - $5Q ² $25,000 = $ 0.00 $5Q = $25,000 Q = 5,000 What quantity demand will earn $1,000? $10Q - $5Q - $25,000 = $ 1,000 $5Q = $26,000 Q = 5,200

Algebraic approach:
Contribution Margin equation
(USP ² UVC) x Q = FC + OI Q = FC + OI UMC Q = $25,000 + 0 $5 Q = 5,000
What quantity needs sold to make $1,000?

Q = $25,000 + $1,000 $5 Q = 5,200

Graphical analysis:
Dollars 70,000 Total Cost 60,000 Line 50,000 40,000 30,000 20,000 Total Revenue 10,000 BreakBreak-even point Line 0 1000 2000 3000 4000 5000 6000 Quantity

Graphical analysis:
Cont.
Dollars 70,000 Total Cost 60,000 Line 50,000 40,000 30,000 20,000 Total Revenue 10,000 BreakBreak-even point Line 0 1000 2000 3000 4000 5000 6000 Quantity

Scenario 1:
BreakBreak-even Analysis Simplified
‡ When total revenue is equal to total cost the process is at the break-even breakpoint. TC = TR

BreakBreak-even Analysis:
Comparing different variables
‡ Company XYZ has to choose between two machines to purchase. The selling price is $10 per unit. ‡ Machine A: annual cost of $3000 with per unit cost (VC) of $5. ‡ Machine B: annual cost of $8000 with per unit cost (VC) of $2.

BreakBreak-even analysis:
Comparative analysis Part 1
‡ Determine break-even point for breakMachine A and Machine B. ‡ Where: V = FC SP - VC

BreakBreak-even analysis:
Part 1, Cont.
Machine A: v = $3,000 $10 - $5 = 600 units Machine B: v = $8,000 $10 - $2 = 1000 units

Part 1: Comparison
‡ Compare the two results to determine minimum quantity sold. ‡ Part 1 shows: ² 600 units are the minimum. ² Demand of 600 you would choose Machine A.

Part 2: Comparison
Finding point of indifference between Machine A and Machine B will give the quantity demand required to select Machine B over Machine A. Machine A FC + VC $3,000 + $5 Q $3Q Q = Machine B = FC + VC = $8,000 + $2Q = $5,000 = 1667

Part 2: Comparison
Cont.
‡ Knowing the point of indifference we will choose: ‡ Machine A when quantity demanded is between 600 and 1667. ‡ Machine B when quantity demanded exceeds 1667.

Part 2: Comparison
Graphically displayed
Dollars 21,000 18,000 Machine A 15,000 12,000 9,000 Machine B 6,000 3,000 0 500 1000 1500 2000 2500 3000 Quantity

Part 2: Comparison
Graphically displayed Cont.
Dollars 21,000 18,000 Machine A 15,000 12,000 9,000 Machine B 6,000 3,000 Point of indifference 0 500 1000 1500 2000 2500 3000 Quantity

Exercise 1:
‡ Company ABC sell widgets for $30 a unit. ‡ Their fixed cost is$100,000 ‡ Their variable cost is $10 per unit. ‡ What is the break-even point using breakthe basic algebraic approach?

Exercise 1:
Answer
Revenues ² Variable cost - Fixed cost = OI

(USP x Q) ² (UVC x Q) ² FC $30Q - $10Q ² $100,00 $20Q Q

= = = =

OI $ 0.00 $100,000 5,000

Exercise 2:
‡ Company DEF has a choice of two machines to purchase. They both make the same product which sells for $10. ‡ Machine A has FC of $5,000 and a per unit cost of $5. ‡ Machine B has FC of $15,000 and a per unit cost of $1. ‡ Under what conditions would you select Machine A?

Exercise 2:
Answer
Step 1: Break-even analysis on both Breakoptions. Machine A: v = $5,000 $10 - $5 = 1000 units Machine B: v = $15,000 $10 - $1 = 1667 units

Exercise 2:
Answer Cont.
Machine A FC + VC $5,000 + $5 Q $4Q Q = Machine B = FC + VC = $15,000 + $1Q = $10,000 = 2500

‡ Machine A should be purchased if expected demand is between 1000 and 2500 units per year.

Summary:
‡ Break-even analysis can be an Breakeffective tool in determining the cost effectiveness of a product. ‡ Required quantities to avoid loss. ‡ Use as a comparison tool for making a decision.

Bibliography:
Russel, Roberta S., and Bernard W. Taylor III. Operations Management. Upper Saddle River, NJ: Pentice-Hall, Pentice2000. Horngren, Charles T., George Foster, and Srikant M. Datar. Cost Account. 10th ed. Upper Saddle River, NJ: PenticePentice-Hall, 2000.