class 25- breakeven analysis

8/21/2019 Class 25- Breakeven Analysis

1/22

Breakeven Analysis


2/22

Introduction

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)

C-V-P analysis is an important tool in terms of

short-termplanning and decision making


3/22

Key Terminologies

Break even point-the point at which acompany makes neither a profit or a loss.

Contribution per unit-the sales price minus

the variable cost per unit. It measures thecontribution made by each item of output to

the fixed costs and profit of the organisation.

Margin of safety-a measure in which thebudgeted volume of sales is compared with

the volume of sales required to break even


4/22

Break Even Formula

Contribution per unit

Is the selling price of a product less variable costs

per unit.

Break-even level of output=

Fixed Cost

Contribution per unit


5/22

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) = FCQB= FC/(PVC)


6/22

Break-even Formula Example

Fixed costs = $200,000

Contribution per unit = $50

What is the Break-even level of output?

Fixed Cost

Contribution per unitBreak-even level of output=

200,000 / 50 = 4000 units


7/22

Graphical Method

The break-even graph shows 3 pieces of

information:

Fixed costs

Total costs (fixed costs + variable costs)

Sales revenue (selling price * units sold)


8/22

Graphical Method Example

The maximum profit is made when the maximum output is produced.

0

Fixed Costs

Variable Costs

Total Costs

Sales Revenue

Break-even point

BE

Profit at full capacity

Full

Capacity

Costsand

revenu

e

Output


9/22

Profit vs Loss

Profits are to the right of the break-even point.

Losses are to the left of the break-even point.

0

Fixed Costs

Variable Costs

Total Costs

Sales Revenue

Break-even point

BE


Profit

Loss

Full

Capacity

Costsand

revenu

e

Output


10/22

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


11/22

Margin of Safety

Margin of safetyis the amount by which the sales level exceeds

the break-even level. If sales drop below this level, a loss will occur.

0

Fixed Costs

Variable Costs

Total Costs

Sales Revenue

Break-even

point

BE


Full

Capacity

Current

Output

Safetymargin

If margin of safety is

positive, production

is above break even.

If margin of safety is

negative, production

is below break even.

Costsand

revenu

e

Output


12/22

Additional Uses of Break-even Analysis

Marketing decision: The impact of price increases

This raises sales revenue line at all quantitiesassumingthat sales do not decline which may be unlikely.

Operations Management decision: Purchase of newequipment with lower variable costs

This lowers the variable cost line at each quantity level.

Choosing between two locations for a new factorywith different fixed and variable costs.


13/22

Target Revenues & Profits

A modified break-even formula can be used to

determine a target profit level.

Target profit level of output=

Target profit is $25,000

Fixed Costs are $200,000

Contribution per unit $50

Fixed Costs + Target Profit

Contribution per Unit

200,000 + 25,000

504500 =

Units


14/22

Break-even Revenue

Break-even Revenue is the amount of revenue

needed to cover bothfixed and variable costs so that

the business breaks even.

Fixed Costs

1(Variable cost / Price)Break-even Revenue =

This is helpful in a service business.

Story: If the monthly fixed costs of a law practice are $60,000, lawyers are paid$15 per hour, and clients are charged a price of $30 per hours, what is the

break-even revenue?

60,000

1(15 / 30)= $120,000

How many hours must they bill?


15/22

Breakeven Between Two Alternatives

To determine value of common variable between 2 alternatives, do thefollowing:

1. Define the common variable2. Develop equivalence PW, AW or FW relations as function of common

variable for each alternative

3. Equate the relations; solve for variable. This is breakeven value

Selection of alternative is based on

anticipated value of common variable:

Value BELOW breakeven;

select higher variable cost

Value ABOVE breakeven;

select lower variable cost


16/22

Example

Alternative A (Make): First cost= 18000,

Salvage Value= 2000 and Per Unit cost of 0.4

Alternative B (Buy): 1.5 per unit.

MARR= 15% and Life= 6 Years


17/22

Example: Two Alternative Breakeven Analysis

Perform a make/buy analysis where the

common variable is X, the number of units

produced each year. AW relations are:

AWmake= -18,000(A/P,15%,6)

+2,000(A/F,15%,6)0.4X

AWbuy = -1.5X

Solution: Equate AW relations, solve for X

-1.5X = -4528 - 0.4X

X = 4116 per year

X, 1000 units per year

Breakeven

value of X

1 2 3 4 5

AWbuy

AWmake

If anticipated production > 4116,

select make alternative (lower variable cost)

AW, 1000

$/year

8

7

6

5

4

3

2

1

0


18/22

Payback Period Analysis

Caution: Payback period analysis is a good initial screeningtool, rather than the primary method to justify a project or

select an alternative (Discussed later)

Payback period: Estimated amount of time (np) for cash inflows to recover aninitial investment (P) plus a stated return of return (i%)

Types of payback analysis: No-returnand discountedpayback

1. No-return payback means rate of return is ZERO (i = 0%)2. Discounted payback considers time value of money (i > 0%)


19/22

Payback Period Computation

Formula to determine payback period (np)

varies with type of analysis.NCF = Net Cash Flow per period t

Eqn. 1

Eqn. 2

Eqn. 3

Eqn. 4


20/22

Points to Remember About Payback Analysis

No-return payback neglects time value of money, so no

return is expected for the investment made No cash flows after the payback period are considered in the

analysis. Return may be higher if these cash flows areexpected to be positive.

Approach of payback analysis is different from PW, AW, RORand B/C analysis. A different alternative may be selected usingpayback.

Rely on payback as a supplemental tool; use PW or AW at the

MARR for a reliable decision Discounted payback (i > 0%) gives a good sense of the risk

involved


21/22

Example: Payback Analysis

System 1 System 2First cost, $ 12,000 8,000NCF, $ per year 3,000 1,000 (year 1-5)

3,000 (year 6-14)Maximum life, years 7 14

Problem: Use (a) no-return payback, (b) discounted payback at

15%, and (c) PW analysis at 15% to select a system. Commenton the results.

Solution: (a) Use Eqns. 1 and 2np1 = 12,000 / 3,000 = 4 years

np2 = -8,000 + 5(1,000) + 1(3,000) = 6 years

Select system 1


22/22

Example: Payback Analysis (continued)System 1 System 2

First cost, $ 12,000 8,000NCF, $ per year 3,000 1,000 (year 1-5)

3,000 (year 6-14)Maximum life, years 7 14

Solution: (b) Use Eqns. 3 and 4System 1: 0 = -12,000 + 3,000(P/A,15%,np1)

np1= 6.6 years

System 2: 0 = -8,000 + 1,000(P/A,15%,5)+ 3,000(P/A,15%,np2- 5)(P/F,15%,5)

np1= 9.5 years

Select system 1

(c) Find PW over LCM of 14 years

PW1= $663PW2= $2470

Select system 2Comment: PW method considers cash flows after payback period.

Selection changes from system 1 to 2

class 25- breakeven analysis

Documents