Production management

Break-Even Analysis

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

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Production management

Benefits and Uses:

• The evaluation to determine necessary
levels of service or production to avoid
loss.

• Comparing different variables to

determine best case scenario.

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Break-Even Analysis TheAs Break-even

Theoutput
Total revenue is
totaltotal
point
costsis
Costs/Revenue The lower the
TR TR TC occurs where
generated,
Initially a by
determined
therefore
the
firm the
price,
revenue the
equals less
total
VC firm
will
price
costs
will
incurincur
charged
(assuming
– the firm,
fixed
and
in
steep
costs,the
variable total
costs
these do– –
thisthe quantity
example
accurate
these vary
sold
would
revenue
have
not
again curve.
depend
thisQ1
to sell will on
tobethe
forecasts!)
directly
output or
determined with byisthe
sales.
generate
sum
amount sufficient
of produced
FC+VC
expected
revenue forecast
to cover its
sales
costs. initially.

FC

Q1 Output/Sales

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Production management

Break-Even Analysis
Costs/Revenue If the firm chose
TR (p = Rs3) TR (p = Rs2) TC to set price higher
VC than Rs2 (say
Rs3) the TR curve
would be steeper –
they would not
have to sell as
many units to
break even

FC

Q2 Q1 Output/Sales

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Break-Even Analysis
TR (p = Rs1)
Costs/Revenue If the firm chose
TR (p = Rs2)
TC to set prices lower
VC (say Rs1) it would
need to sell more
units before
covering its costs

FC

Q1 Q3 Output/Sales

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Production management

Break-Even Analysis
TR (p = Rs2)
Costs/Revenue TC
Profit VC

Loss
FC

Q1 Output/Sales

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Break-Even Analysis Margin of

TR (p = Rs3) TR (p = Rs2)
TC A higher
safety showsprice
Costs/Revenue
would lower
how far sales
VC can fall
the before
break
Assume
losses made. If
even
current
Q1
pointand
= 1000sales
and
Q2 the
at Q2 sales
= 1800,
margin
could fallof
by 800
units before
safety woulda
loss would be
widen
made

Margin of Safety
FC

Q3 Q1 Q2 Output/Sales

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Production management

Costs/Revenue
Eurotunnel’s
High initial FC.
FC 1
Interest on debt
problem
rises each year – FC
rise therefore
FC
Losses get
bigger!
TR
VC

Output/Sales

Copyright 2004 – Biz/ed

Break-Even Analysis
• Remember:
• A higher price or lower price does
not mean that break even will
never be reached!
• The BE point depends on the
number of sales needed to
generate revenue to cover costs –
the BE chart is NOT time related!

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Production management

Break-Even Analysis
• Importance of Price Elasticity of
Demand:
• Higher prices might mean fewer sales
to break-even but those sales may take
a longer time to achieve.
• Lower prices might encourage more
customers but higher volume needed
before sufficient revenue generated to
break-even

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Break-Even Analysis
• Links of BE to pricing strategies and
elasticity
• Penetration pricing – ‘high’ volume,
‘low’ price – more sales to break even
• Market Skimming – ‘high’ price ‘low’
volumes – fewer sales to break even
• Elasticity – what is likely to happen to
sales when prices are increased or
decreased?

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Production management

Break-even analysis:
Break-even point
• John sells a product for Rs10 and it cost
Rs5 to produce (UVC) and has fixed
cost (FC) of Rs25,000 per year

• How much will he need to sell to break-

even?

• How much will he need to sell to make

Rs1000?

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• USP = Unit Selling Price

• UVC = Unit Variable costs

• FC = Fixed Costs

• Q = Quantity of output units

sold (and manufactured)

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Production management

• OI = Operating Income

• TR = Total Revenue

• TC = Total Cost

• USP = Unit Selling Price

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Algebraic approach:
Basic equation
Revenues – Variable cost – Fixed cost = OI
(USP x Q) – (UVC x Q) – FC = OI
Rs10Q - Rs5Q – Rs25,000 = Rs 0.00
Rs5Q = Rs25,000
Q = 5,000
What quantity demand will earn Rs1,000?

10Q - 5Q - 25,000 = 1,000

5Q = 26,000
Q = 5,200

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Production management

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 Rs1,000?
Q = 25,000 + 1,000
5
Q = 5,200
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Graphical analysis:

Rs
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

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Production management

Graphical analysis:
Cont.

Rs
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
Copyright 2004 – Biz/ed

Scenario 1:
Break-even Analysis Simplified

• When total revenue is equal to total

cost the process is at the break-even
point.

TC = TR

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Production management

Break-even Analysis:
Comparing different variables

• Company XYZ has to choose between

two machines to purchase. The selling
price is Rs10 per unit.

• Machine A: annual cost of Rs3000 with

per unit cost (VC) of Rs5.

• Machine B: annual cost of Rs8000 with

per unit cost (VC) of Rs2.

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Break-even analysis:
Comparative analysis Part 1

• Determine break-even point for

Machine A and Machine B.

• Where: V = FC
SP - VC

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Production management

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

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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.

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Production management

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 + 5Q = 8,000 + 2Q
3Q = 5,000
Q = 1667

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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.

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Production management

Part 2: Comparison
Graphically displayed

Rs
21,000
Machine A
18,000
15,000
12,000
9,000 Machine B

6,000
3,000
0
500 1000 1500 2000 2500 3000
Quantity

Copyright 2004 – Biz/ed

Part 2: Comparison
Graphically displayed Cont.

Rs
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
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Production management

Exercise 1:
• Company ABC sell widgets for Rs30 a
unit.

• Their fixed cost is Rs100,000

• Their variable cost is Rs10 per unit.

• What is the break-even point using the

basic algebraic approach?

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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

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Production management

Exercise 2:
• Company DEF has a choice of two
machines to purchase. They both make
the same product which sells for Rs10.
• Machine A has FC of Rs5,000 and a per
unit cost of Rs5.
• Machine B has FC of Rs15,000 and a
per unit cost of Rs1.

• Under what conditions would you select

Machine A?

Copyright 2004 – Biz/ed

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

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Production management

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.

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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.

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