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Break-Even Analysis

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

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Break-Even Analysis

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  1. Break-Even Analysis Greg Hiatt May 5, 2002

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

  3. Overview: Break-Even Analysis • Benefits • Defining Page • Getting Started • Break-even Analysis • Break-even point • Comparing variables • Algebraic Approach • Graphical Approach

  4. Benefits and Uses: • The evaluation to determine necessary levels of service or production to avoid loss. • Comparing different variables to determine best case scenario.

  5. Defining Page: • USP = Unit Selling Price • UVC = Unit Variable costs • FC = Fixed Costs • Q = Quantity of output units sold (and manufactured)

  6. Defining Page: Cont. • OI = Operating Income • TR = Total Revenue • TC = Total Cost • USP = Unit Selling Price

  7. Getting Started: • Determination of which equation method to use: • Basic equation • Contribution margin equation • Graphical display

  8. 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?

  9. 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

  10. 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

  11. Graphical analysis: Dollars 70,000 60,000 50,000 40,000 30,000 20,000 10,000 Break-even point 0 1000 2000 3000 4000 5000 6000 Quantity Total Cost Line Total Revenue Line

  12. Graphical analysis:Cont. Dollars 70,000 60,000 50,000 40,000 30,000 20,000 10,000 Break-even point 0 1000 2000 3000 4000 5000 6000 Quantity Total Cost Line Total Revenue Line

  13. Scenario 1: Break-even Analysis Simplified • When total revenue is equal to total cost the process is at the break-even point. TC = TR

  14. 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.

  15. Break-even analysis:Comparative analysis Part 1 • Determine break-even point for Machine A and Machine B. • Where: V = FC SP - VC

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

  17. 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.

  18. 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

  19. Part 2: ComparisonCont. • 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.

  20. Part 2: ComparisonGraphically displayed Dollars 21,000 18,000 15,000 12,000 9,000 6,000 3,000 0 500 1000 1500 2000 2500 3000 Quantity Machine A Machine B

  21. Part 2: ComparisonGraphically displayed Cont. Dollars 21,000 18,000 15,000 12,000 9,000 6,000 3,000 Point of indifference 0 500 1000 1500 2000 2500 3000 Quantity Machine A Machine B

  22. 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?

  23. 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

  24. 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?

  25. 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

  26. 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.

  27. 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.

  28. 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.

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