Break-Even Analysis

Defined:
Break-even analysis examines the cost tradeoffs associated with demand volume. OR Break even analysis examines relationship between total revenue, total costs & total profit at various level of output

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

= Unit Selling Price

= Unit Variable costs = Fixed Costs

= Quantity of output units sold (and manufactured)

Defining Page:
Cont.
OI
TR TC

= Operating Income
= Total Revenue = 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 Rs.10 and it cost Rs.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 Rs.1000?

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

(USP x Q) (UVC x Q) FC = OI Rs.10Q - Rs.5Q Rs.25,000 Rs. 0.00 Rs.5Q = Rs.25,000 Q = 5,000

What quantity demand will earn Rs.1,000? Rs.10Q - Rs.5Q Rs.25,000 = Rs. 1,000

Algebraic approach:

Contribution Margin equation

(USP UVC) x Q = FC + OI Q = FC + OI UMC Q = Rs.25,000 + 0 Rs.5 Q = 5,000
What quantity needs sold to make Rs.1,000?

Rs.1,000

Q = Rs.25,000 +

Rs.5

Graphical analysis:
Dollars 70,000 60,000 Total Cost Line 50,000 40,000 30,000 20,000 Total Revenue 10,000 Break-even point Line 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 Break-even point Line 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 Rs.10 per unit.
Machine A: annual cost of Rs.3000 with per unit cost (VC) of Rs.5.

Machine B: annual cost of Rs.8000 with per unit cost (VC) of Rs.2.

Break-even analysis:
Determine break-even point for Machine A and Machine B. Where: V = FC SP - VC

Comparative analysis Part 1

Break-even analysis:
Part 1, Cont.
Machine A:
v = Rs.3,000 Rs.10 - Rs.5 = 600 units Machine B: v = Rs.8,000 Rs.10 - Rs.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 FC + VC Rs.3,000 + Rs.5 Rs.2Q Rs.3Q Q = = Q Machine B FC + VC = Rs.8,000 +

= Rs.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 Rs.30 a unit. Their fixed cost isRs.100,000
Their variable cost is Rs.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 Rs.30Q - Rs.10Q Rs.100,00 = Rs. 0.00 Rs.20Q = Rs.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 Rs.10. Machine A has FC of Rs.5,000 and a per unit cost of Rs.5. Machine B has FC of Rs.15,000 and a per unit cost of Rs.1.
Under what conditions would you select Machine A?

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

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

= Rs.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 effective tool in determining the cost effectiveness of a product.
Required quantities to avoid loss.

Use as a comparison tool for making a decision.