Break-Even Analysis

Greg Hiatt
May 5, 2002
Defined:
Break-even analysis examines the
cost tradeoffs associated with
demand volume.
Overview:
Break-Even Analysis

Benefits
Defining Page
Getting Started
Break-even Analysis
Break-even point
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 = Unit Selling Price

UVC = Unit Variable costs

FC = Fixed Costs

Q = Quantity of output units

sold (and manufactured)
Defining Page:
Cont.

OI = Operating Income

TR = Total Revenue

TC = Total Cost

USP = Unit Selling Price

Getting Started:
Determination of which equation
method to use:
Basic equation
Contribution margin equation
Graphical display
Break-even analysis:
Break-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

break-even?

How much will he need to sell to

make $1000?
Algebraic approach:
Basic equation
Revenues Variable cost Fixed cost = OI
(USP x Q) (UVC x Q) FC = OI
$10Q - $5Q $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 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
60,000 Total Cost
Line
50,000
40,000
30,000
20,000
Total Revenue
10,000 Line Break-even point
0
1000 2000 3000 4000 5000 6000
Quantity
Graphical analysis:
Cont.
Dollars
70,000
60,000 Total Cost
Line
50,000
40,000
30,000
20,000
Total Revenue
10,000 Line Break-even point
0
1000 2000 3000 4000 5000 6000
Quantity
Scenario 1:
Break-even Analysis Simplified

When total revenue is equal to total

cost the process is at the break-even
point.

TC = TR
Break-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.
Break-even analysis:
Comparative analysis Part 1

Determine break-even point for

Machine A and Machine B.

Where: V = FC
SP - VC
Break-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:
600 units are the minimum.
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 = Machine B
FC + VC = FC + VC
$3,000 + $5 Q = $8,000 + $2Q
$3Q = $5,000
Q = 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

the basic algebraic approach?
 Exercise 1:
Answer

Revenues Variable cost - Fixed cost = OI

(USP x Q) (UVC x Q) FC = OI
$30Q - $10Q $100,00 = $ 0.00
$20Q = $100,000
Q = 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
options.
Machine A:
v = $5,000
$10 - $5
= 1000 units
Machine B:
v = $15,000
$10 - $1
= 1667 units
Exercise 2:
Answer Cont.
Machine A = Machine B
FC + VC = FC + VC
$5,000 + $5 Q = $15,000 + $1Q
$4Q = $10,000
Q = 2500

Machine A should be purchased if

expected demand is between 1000
and 2500 units per year.
Summary:
Break-even analysis can be an
effective 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,
2000.
Horngren, Charles T., George Foster,
and Srikant M. Datar. Cost Account.
10th ed. Upper Saddle River, NJ:
Pentice-Hall, 2000.