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Break-Even Analysis

• Study of
interrelationships $’s TC
among a firm’s sales,
costs, and operating TR
profit at various levels
of output
• Break-even point is
the Q where TR = TC Profit
Q
(Q1 to Q2 on graph) Q1 Q2
Linear Break-Even Analysis
• Over small enough range of output levels TR and
TC may be linear, assuming
– Constant selling price (MR)
– Constant marginal cost (MC)
– Firm produces only one product
– No time lags between investment and resulting
revenue stream
Graphic Solution Method

• Draw a line through TR


origin with a slope of P $’s
TC
(product price) to
represent TR function MC
• Draw a line that 1 unit Q
intersects vertical axis
at level of fixed cost FC
and has a slope of MC P

• Intersection of TC and 1 unit Q Q


Break-even
TR is break-even point point
Algebraic Solution
• Equate total revenue and total cost functions and solve for Q
TR = P x Q
TC = FC + (VC x Q)
TR = TC
P x QB = FC + VC x QB
(P x QB) – (VC x QB) = FC
QB (P – VC) = FC
QB = FC/(P – VC), or in terms of total dollar sales,

PQ = (FxP)/(P-VC) = ((FxP)/P)/((P-VC)/P) = F/((P/P) – (VC/P))


= F/(1-VC/P)
Related Concepts

• Profit contribution = P – VC
– The amount per unit of sale contributed to
fixed costs and profit
• Target volume = (FC + Profit)/(P – VC)
– Output at which a targeted total profit would
be achieved
Example 1 – how many Christmas trees
need to be sold

• Wholesale price per tree is $8.00


• Fixed cost is $30,000
• Variable cost per tree is $5.00
• Solution
Q(break-even) = F/(P – VC) = $30,000/($8 - $5)
= $30,000/$3 = 10,000 trees
Example 2 – two production methods to
accomplish same task
• Method I : TC1 = FC1 + VC1 x Q
• Method II : TC2 = FC2 + VC2 x Q
• At break-even point:
FC1 + (VC1 x Q) = FC2 + (VC2 x Q)

(VC1 x Q) – (VC2 x Q) = FC2 – FC1

Q x (VC1 – VC2) = FC2 – FC1

Q = (FC2 – FC1)/(VC1 – VC2)


Example 2 continued: bowsaw or chainsaw to
cut Christmas trees

• Bowsaw
– Fixed cost is $5.00
– Variable cost is $0.40 per
• Chainsaw
• Fixed cost is $305
• Variable cost is $0.10 per tree
• Solution
Q(break-even) = ($305 - $5)/($0.40 - $0.10)
= 300/.30 = 1,000 trees
Revenue and Cost as
Function of a Single Input
• Marginal Revenue Product
– Increase in revenue per unit increase in one
input
– = MR / (Xt+1 – X t )
• Marginal Factor Cost
– Increase in cost per unit increase in one input
– =MC / (Xt+1 – X t )
• Go to Spreadsheet
Example 3: Optimal planting density

No. Trees per A @ Yield in cords @ Total Revenue


5 years rotation @$24/cord
300 21.3 511
400 23.4 562
500 25.2 605
600 26.7 641
700 28.0 672
800 29.1 698
900 30.1 722
Example 3: Continued

• Variable
Fixed costs
costs
perper
acre:
100 seedlings
– Seedlings
Land . . . . .. .. .. . $300
$5
– Planting
Site prep ........ 20 100
– Annual
Total . .. .. .. . 2560
– Set-up . . . . . 5
– Total . . . . 465
TC = 465 + 25 x (# trees per A/100)

Go to Spreadsheet

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