INTRODUCTION INTRODUCTION
The point at which neither profit nor loss made was known as the
A breakeven analysis is used to determine how much sales "break-
break-even point"
point" and is represented on the chart by the
volume your business needs to start making a profit. intersection of the two lines:
¾ The line OA represents the variation
The breakeven analysis is especially useful when you're of income at varying levels of
production activity ("output").
developing a pricing strategy, either as part of a marketing ¾ OB represents the total fixed costs in
plan or a business plan. the business. As output increases,
variable costs are incurred, meaning
that total costs (fixed + variable)
The break-
break-even chart is a graphical representation of costs also increase.
at various levels of activity shown on the same chart as the ¾ At low levels of output, Costs are
greater than Income.
variation of income (or sales, revenue) with the same ¾ At the point of intersection, P, costs
variation in activity. are exactly equal to income, and
hence neither profit nor loss is made.
Fixed Costs divided by (Revenue per unit - Variable costs per unit)
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INTRODUCTION
Conducting an accurate break-even analysis requires a careful
examination and study of costs and prices in your business. You
must know what your product or service costs in total to deliver to
the final customer, as well as the price you can charge for the product
or service. Include and deduct all miscellaneous expenses involved in Breakeven Analysis for a
operating your business.
To get started, analyze every product or service you produce and Single Project
sell on a regular basis. Make a list of these products or services,
starting from the largest volume seller. Next, calculate the average
sales price of each unit, and then calculate the total cost of each unit.
Then, calculate the net profit that you earn on the sale of each unit,
and calculate the cost of the investment to produce and sell each
unit. Determine the percentage of return/profit that you earn from the
sale of each unit.
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¾ A breakeven value can be determined by 2. Trial and Error – manually if multiple factors are
setting PW, FW, or AW = 0 and solve or present in the formulation;
approximate for the unknown parameter.
3. Spreadsheet model where the Excel financial
functions { PV, FV, RATE, IRR, NPV, PMT, and NPER
are part of the modeling process: (use Goal Seek or Solver).
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A Cost – Revenue Model Approach Cost Models – Fixed Costs
A popular application of Breakeven (BE) is where cost Fixed Costs – Cost that do not vary with
– revenue – volume relationships are studied; production or activity levels
We define cost and revenue functions and assume Costs of buildings;
some linear or non-
non-linear cost or revenue relationships Insurance;
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Variable Costs Total Costs
Variable Costs change with the level of Total Cost = Fixed Costs + Variable Costs:
activity:
TC = FC + VC;
More activity – greater variable costs; Profit Relationships;
Less activity – lover variable costs; Profit = Revenue – Total Cost
Variable costs are impacted by efficiency of operation, P = R – TC
improved designs, quality, safety, and higher sales P = R –{FC + VC}.
volume.
Linear models Fixed costs - do not vary (e.g., lease costs, rent,
Non-
Non-linear models insurance)
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Breakeven Volume Breakeven Volume (cont’d)
¾ Total Variable Cost (VC) is a function of volume (x) Find x such that:
of units sold.
Price/unit * x = Fixed + VC/unit * x
¾ Total VC = Variable Cost/unit * x
Total Costs
C
O
S
T
Variable Costs
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Total Revenue is based on volume and selling price/unit.
Variable Cost + Fixed Cost Where the Revenue and Total Cost lines intersect is the Break
Total Cost goes up with volume because Variable Cost increases Even (BE) Point. That volume is the BE Volume
Profit Loss
Above the BE point, the difference between the Revenue and Total Cost If volume is below the BE point, the difference between the lines
lines
lines represents profit represents a loss
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Assumptions of Linear Breakeven Analysis Breakeven Applications
Costs can be subdivided into fixed and New product decision: breakeven analysis
variable components determines sales volume required to break even
Pricing decision: breakeven analysis gives effect of
All cost-volume-profit relationships are linear changing prices and volume relationships on total
Sales price will not change with changes in profit
volume Modernization or automation decisions: breakeven
analysis reveals profit implications of substituting
Linearity assumptions are valid for a broad fixed costs for variable costs
range of applications Expansion decisions: breakeven analysis can be
used to analyze aggregate effect of general
Nonlinear breakeven analysis allows for expansion
nonlinear relationships
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Breakeven Breakeven
The breakeven point, QBE is the point where the Revenue and Total cost relationships tend to be static
in nature;
revenue and total cost relationships intersect:
May not truly reflect reality of the dynamic firm;
For non-linear forms, it is possible to have more
However, the breakeven point(s) can be useful for
than one QBE point. planning purposes.
Breakeven Points
And Profit
Maximization for
A Non-linear Model
.
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Two Alternative Analysis
Given two alternatives (assume mutually exclusive)
Need to determine a common variable or
economic parameter common to both
Breakeven Analysis Between alternatives;
Two Alternatives Interestrate,
Firstcost (investment),
Annual operating cost,
Etc.
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Two Alternative Analysis Three Alternative Analysis
CASE
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Case 1 - Decrease Fixed Cost
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Case 3 - Increase Selling Price/Unit
From economics we know that elasticity of
demand is important. We cannot raise prices
without being concerned about the effect on
sales volume.
Suppose that through engineering
improvements we developed the highest quality
product in our market and customers are willing
to pay for it. We can raise our selling price.
Raising the Selling Price without lowering
volume increases profits considerably.
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BE Analysis Example BE Analysis Example (cont’d)
Fixed Cost = $500K (leased equip. and space) What is the projected profit from this project?
Cost per unit: Profit = Revenue - Expenses
Direct Labor: 0.5 hours @ $10/hr = $5/unit = ($35 * 50,000) - $500K - ($23 * 50,000)
Material: 2 lbs @ $7/lb = $14/unit = $1,750,000 - $500,000 - $1,150,000
Overhead: $8/DL hour burden rate = $4 = $100,000
Total Variable Cost = $5 + $14 + $4 = $23/unit BE volume = Fixed / (SP/unit - VC/unit)
Selling price/unit = $35 (based on competition) = $500,000/ ($35 - $23)
Projected Sales: 50,000 units = 41,667 units
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In Summary: Engineering Value Summary
Notice that each improvement mentioned was not far Breakeven point for a variable X is normally
off from the annual salary of an engineer. Engineers expressed as:
are in a position to greatly increase profits by:
Units per time period;
Reducing fixed costs
Hours per month;
Reducing labor, material and overhead costs
Etc.
Increasing the quality and value of the product
Increasing sales demand of the product At breakeven, QBE one is indifferent regarding a
project.
Summary
Typical models are:
Linear
Non-
Non-linear.
Two or more alternatives can be compared using
breakeven analysis END
BE analysis can be a form of sensitivity analysis
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