Break-Even Analysis
Decision making and Breakeven Analysis: Examples
How many units must be sold to breakeven? How many units must be sold to achieve a target profit? Should a special order be accepted? How will profits be affected if we introduce a new product or service?
Breakeven Analysis Defined
Breakeven analysis examines the short run relationship between changes in volume and changes in total sales revenue, expenses and net profit Also known as C-V-P analysis (Cost Volume Profit Analysis)
Overview: Break-Even Analysis
Benefits Defining Page 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.
Benefits and Uses:
C-V-P analysis is an important tool in terms of short-term planning and decision making It looks at the relationship between costs, revenue, output levels and profit Short run decisions where C-V-P is used include choice of sales mix, pricing policy etc.
Key Terminology: Breakeven Analysis
Break even point - the point at which a company makes neither a profit or a loss.
Contribution per unit - The sales price minus the variable cost per unit. It measures the contribution made by each item of output to the fixed costs and profit of the organisation. (Contribution/unit= Selling price/unit Variable cost/unit) Margin of safety - A measure in which the budgeted volume of sales is compared with the volume of sales required to break even Marginal Cost Cost of producing one extra unit of output (Incremental cost, Variable cost)
Margin of Safety
The difference between budgeted or actual sales and the breakeven point The margin of safety may be expressed in units or revenue terms Shows the amount by which sales can drop before a loss will be incurred
(Margin of safety = |Actual sale Sales @ BEP|)
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
Breakeven Formula
Fixed Costs *Contribution per unit
*Contribution per unit = Selling Price per unit Variable Cost per unit
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 Rs.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 Rs.5Q = Rs.26,000 Q = 5,200
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
= Rs.25,000 + Rs.1,000 Rs.5 = 5,200
What quantity needs sold to make Rs.1,000?
Q Q
Graphical analysis:
Dollars 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0
Total Cost Line
Total Revenue Line
Break-even point
1000 2000 3000 4000 5000 6000 Quantity
Graphical analysis: Cont.
Rs. 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0
Total Cost Line
Total Revenue Line
Break-even point
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: Comparative analysis Part 1
Determine break-even point for Machine A and Machine B. Where: BEP = FC SP - VC
Break-even analysis: Part 1, Cont.
Machine A:
v = Rs.3,000 Rs.10 - Rs.5 600 units Rs.8,000 Rs.10 - Rs.2 1000 units
=
Machine B: v = =
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.5Q Rs.3Q Q = Machine B = FC + VC = Rs.8,000 + Rs.2Q = 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 15,000 12,000 9,000 6,000 3,000 0
Machine A
Machine B
500 1000 1500 2000 2500 3000 Quantity
Part 2: Comparison Graphically displayed Cont.
Rs. 21,000 18,000 15,000 12,000 9,000 6,000 3,000 0
Machine A
Machine B Point of indifference
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.5Q Rs.4Q Q = Machine B = FC + VC = Rs.15,000 + Rs.1Q = 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.
