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.

ADVANTAGES
Easy to understand and use
Profit and loss is easy to calculate at
different levels of output
The impact of a change to cost can
be measured by changing TC line
Can measure the impact of a price
change by moving the TR line
Allows a company to carry out a
what if analysis

Disadvantages
Is too simplistic in assuming
that all prices / cost are
constant
Any conclusion drawn are only
as accurate as the date they are
based on
Assume that all output is sold

Defining Page:
USP

= Unit Selling Price

UVC

= Unit Variable costs

FC

= Fixed Costs

= 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
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 $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
FC + VC
$3,000 + $5 Q
$3Q
Q

=
Machine B
=
FC + VC
= $8,000 + $2Q
= $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 $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
$30Q - $10Q $100,00
$20Q
Q

=
=
=
=

OI
$ 0.00
$100,000
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
FC + VC
$5,000 + $5 Q
$4Q
Q

=
Machine B
=
FC + VC
= $15,000 + $1Q
= $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.

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.