Upcoming SlideShare
×

# Break even analysis

9,864 views

Published on

Published in: Business, Technology
2 Likes
Statistics
Notes
• Full Name
Comment goes here.

Are you sure you want to Yes No
Your message goes here
• Be the first to comment

Views
Total views
9,864
On SlideShare
0
From Embeds
0
Number of Embeds
4
Actions
Shares
0
173
0
Likes
2
Embeds 0
No embeds

No notes for slide
• Definition (Russell “operational management” p.236)
• Acronyms and terms (Horngren “Cost Accounting” p. 63) Unit selling price: The price received by the manufacture per unit sold. Unit variable cost: Cost that change in proportion to the changes in the level of activity. Fixed cost: Cost that remain unchanged over a given period regardless of the change in activity.
• Operating income:Total revenues from operation minus cost of goods sold and operating cost. Total revenue: Total revenue that a company takes in. Total cost: All cost related to the companies operations.
• Equation (Horngren “Cost Accounting” p. 63)
• Equation (Horngren “Cost Accounting” p. 64) UMC = \$10 - \$5 = \$5
• Total cost line is a linear line based on the equation: y = VC*Q + FC y = \$5Q + \$25,000 Total revenue line is a linear line based on the equation y = USP * Q y = \$10 * Q Break-even point is where TR = TC.
• Any quantity sold in the red colored region will produce a loss, while any quantity in the green region will produce a positive cash flow
• Equation (Russel “Operational Management” p.240)
• The first step in finding out which process and/or machine is preferred is to find out the break-even point of each option.
• By analyzing the break-even analysis we can see that a quantity demanded of less than 600 units would produce a loss for both Machine A and Machine B.
• Point of indifference identifies the quantity demanded amount where either machine (or process) will suffice. Below the point of indifference Machine A will be a good choice. The reason is that the fixed cost is lower and for smaller quantities demanded Machine A will cost less to operate. Above the point of indifference Machine B will be the best choice. The reason is that the variable cost is lower and for larger quantities demanded Machine B will cost less to operate.
• The solution procedure for selecting the correct machine and/or process. Formulate a total cost equation for each variable. Calculate the point of indifference. Above the point of indifference choose the alternative with the lowest variable cost. Below the point of indifference choose the alternative with the lowest fixed cost.
• The Machine A line is a linear line based on the equation: y = UVC*Q + FC y = \$5Q + \$3,000 The Machine B line is a linear line based on the equation y = UVC * Q + FC y = \$2 * Q + \$8,000 *The higher the VC the steeper the slope.
• Red filled area is when neither machine should be purchased. The red area represents the quantity demanded between 0 and 600. Pink filled area is when Machine A should be purchased. The pink area represents quantity demanded between 600 and 1667. Green filled area is when Machine B should be purchased. The green area represents the quantities demanded of 1667 and above.
• Company ABC will break even when they sell 5000 units of their widgets.
• If answer is not a whole number then round to the nearest dollar.
• ### Break even analysis

1. 1. Defined: <ul><li>Break-even analysis examines the cost tradeoffs associated with demand volume. </li></ul>
2. 2. Overview: Break-Even Analysis <ul><li>Benefits </li></ul><ul><li>Defining Page </li></ul><ul><li>Getting Started </li></ul><ul><li>Break-even Analysis </li></ul><ul><ul><li>Break-even point </li></ul></ul><ul><ul><li>Comparing variables </li></ul></ul><ul><li>Algebraic Approach </li></ul><ul><li>Graphical Approach </li></ul>
3. 3. Benefits and Uses: <ul><li>The evaluation to determine necessary levels of service or production to avoid loss. </li></ul><ul><li>Comparing different variables to determine best case scenario. </li></ul>
4. 4. Defining Page: <ul><li>USP = Unit Selling Price </li></ul><ul><li>UVC = Unit Variable costs </li></ul><ul><li>FC = Fixed Costs </li></ul><ul><li>Q = Quantity of output units sold (and manufactured) </li></ul>
5. 5. Defining Page: Cont. <ul><li>OI = Operating Income </li></ul><ul><li>TR = Total Revenue </li></ul><ul><li>TC = Total Cost </li></ul><ul><li>USP = Unit Selling Price </li></ul>
6. 6. Getting Started: <ul><li>Determination of which equation method to use: </li></ul><ul><ul><li>Basic equation </li></ul></ul><ul><ul><li>Contribution margin equation </li></ul></ul><ul><ul><li>Graphical display </li></ul></ul>
7. 7. Break-even analysis: Break-even point <ul><li>John sells a product for \$10 and it cost \$5 to produce (UVC) and has fixed cost (FC) of \$25,000 per year </li></ul><ul><li>How much will he need to sell to break-even? </li></ul><ul><li>How much will he need to sell to make \$1000? </li></ul>
8. 8. Algebraic approach: Basic equation <ul><li>Revenues – Variable cost – Fixed cost = OI </li></ul><ul><li>(USP x Q) – (UVC x Q) – FC = OI </li></ul><ul><li> \$10Q - \$5Q – \$25,000 = \$ 0.00 </li></ul><ul><li> \$5Q = \$25,000 </li></ul><ul><li> Q = 5,000 </li></ul><ul><li>What quantity demand will earn \$1,000? \$10Q - \$5Q - \$25,000 = \$ 1,000 </li></ul><ul><li>\$5Q = \$26,000 </li></ul><ul><li> Q = 5,200 </li></ul>
9. 9. Algebraic approach: Contribution Margin equation <ul><li> (USP – UVC) x Q = FC + OI </li></ul><ul><li> Q = FC + OI </li></ul><ul><li> UMC </li></ul><ul><li> Q = \$25,000 + 0 </li></ul><ul><li> \$5 </li></ul><ul><li> Q = 5,000 </li></ul><ul><li>What quantity needs sold to make \$1,000? </li></ul><ul><li> Q = \$25,000 + \$1,000 </li></ul><ul><li> \$5 </li></ul><ul><li> Q = 5,200 </li></ul>
10. 10. Graphical analysis: <ul><li>Dollars </li></ul><ul><li>70,000 </li></ul><ul><li>60,000 </li></ul><ul><li>50,000 </li></ul><ul><li>40,000 </li></ul><ul><li>30,000 </li></ul><ul><li>20,000 </li></ul><ul><li>10,000 Break-even point </li></ul><ul><li>0 </li></ul><ul><li> 1000 2000 3000 4000 5000 6000 </li></ul><ul><li> Quantity </li></ul>Total Revenue Line Total Cost Line
11. 11. Graphical analysis: Cont. <ul><li>Dollars </li></ul><ul><li>70,000 </li></ul><ul><li>60,000 </li></ul><ul><li>50,000 </li></ul><ul><li>40,000 </li></ul><ul><li>30,000 </li></ul><ul><li>20,000 </li></ul><ul><li>10,000 Break-even point </li></ul><ul><li>0 </li></ul><ul><li> 1000 2000 3000 4000 5000 6000 </li></ul><ul><li> Quantity </li></ul>Total Cost Line Total Revenue Line
12. 12. Scenario 1: Break-even Analysis Simplified <ul><li>When total revenue is equal to total cost the process is at the break-even point. </li></ul><ul><li> TC = TR </li></ul>
13. 13. Break-even Analysis: Comparing different variables <ul><li>Company XYZ has to choose between two machines to purchase. The selling price is \$10 per unit. </li></ul><ul><li>Machine A: annual cost of \$3000 with per unit cost (VC) of \$5. </li></ul><ul><li>Machine B: annual cost of \$8000 with per unit cost (VC) of \$2. </li></ul>
14. 14. Break-even analysis: Comparative analysis Part 1 <ul><li>Determine break-even point for Machine A and Machine B. </li></ul><ul><li>Where: V = FC </li></ul><ul><li> SP - VC </li></ul>
15. 15. Break-even analysis: Part 1, Cont. <ul><li>Machine A: </li></ul><ul><li> v = \$3,000 </li></ul><ul><li> \$10 - \$5 </li></ul><ul><li>= 600 units </li></ul><ul><li>Machine B: </li></ul><ul><li> v = \$8,000 </li></ul><ul><li> \$10 - \$2 </li></ul><ul><li> = 1000 units </li></ul>
16. 16. Part 1: Comparison <ul><li>Compare the two results to determine minimum quantity sold. </li></ul><ul><li>Part 1 shows: </li></ul><ul><ul><li>600 units are the minimum. </li></ul></ul><ul><ul><li>Demand of 600 you would choose Machine A. </li></ul></ul>
17. 17. Part 2: Comparison <ul><ul><li>Finding point of indifference between Machine A and Machine B will give the quantity demand required to select Machine B over Machine A. </li></ul></ul><ul><ul><li>Machine A = Machine B </li></ul></ul><ul><ul><li>FC + VC = FC + VC </li></ul></ul><ul><ul><li>\$3,000 + \$5 Q = \$8,000 + \$2Q </li></ul></ul><ul><ul><li> \$3Q = \$5,000 </li></ul></ul><ul><ul><li> Q = 1667 </li></ul></ul>
18. 18. Part 2: Comparison Cont. <ul><li>Knowing the point of indifference we will choose: </li></ul><ul><li>Machine A when quantity demanded is between 600 and 1667. </li></ul><ul><li>Machine B when quantity demanded exceeds 1667. </li></ul>
19. 19. Part 2: Comparison Graphically displayed <ul><li>Dollars </li></ul><ul><li>21,000 </li></ul><ul><li>18,000 </li></ul><ul><li>15,000 </li></ul><ul><li>12,000 </li></ul><ul><li>9,000 </li></ul><ul><li>6,000 </li></ul><ul><li>3,000 </li></ul><ul><li>0 </li></ul><ul><li> 500 1000 1500 2000 2500 3000 </li></ul><ul><li> Quantity </li></ul>Machine A Machine B
20. 20. Part 2: Comparison Graphically displayed Cont. <ul><li>Dollars </li></ul><ul><li>21,000 </li></ul><ul><li>18,000 </li></ul><ul><li>15,000 </li></ul><ul><li>12,000 </li></ul><ul><li>9,000 </li></ul><ul><li>6,000 </li></ul><ul><li>3,000 Point of indifference </li></ul><ul><li>0 </li></ul><ul><li> 500 1000 1500 2000 2500 3000 </li></ul><ul><li> Quantity </li></ul>Machine A Machine B
21. 21. Exercise 1: <ul><li>Company ABC sell widgets for \$30 a unit. </li></ul><ul><li>Their fixed cost is\$100,000 </li></ul><ul><li>Their variable cost is \$10 per unit. </li></ul><ul><li>What is the break-even point using the basic algebraic approach? </li></ul>
22. 22. Exercise 1: Answer <ul><li>Revenues – Variable cost - Fixed cost = OI </li></ul><ul><li>(USP x Q) – (UVC x Q) – FC = OI </li></ul><ul><li> \$30Q - \$10Q – \$100,00 = \$ 0.00 </li></ul><ul><li> \$20Q = \$100,000 </li></ul><ul><li> Q = 5,000 </li></ul>
23. 23. Exercise 2: <ul><li>Company DEF has a choice of two machines to purchase. They both make the same product which sells for \$10. </li></ul><ul><li>Machine A has FC of \$5,000 and a per unit cost of \$5. </li></ul><ul><li>Machine B has FC of \$15,000 and a per unit cost of \$1. </li></ul><ul><li>Under what conditions would you select Machine A? </li></ul>
24. 24. Exercise 2: Answer <ul><li>Step 1: Break-even analysis on both options. </li></ul><ul><li>Machine A: </li></ul><ul><li> v = \$5,000 </li></ul><ul><li> \$10 - \$5 </li></ul><ul><li>= 1000 units </li></ul><ul><li>Machine B: </li></ul><ul><li> v = \$15,000 </li></ul><ul><li> \$10 - \$1 </li></ul><ul><li> = 1667 units </li></ul>
25. 25. Exercise 2: Answer Cont. <ul><ul><li>Machine A = Machine B </li></ul></ul><ul><ul><li>FC + VC = FC + VC </li></ul></ul><ul><ul><li>\$5,000 + \$5 Q = \$15,000 + \$1Q </li></ul></ul><ul><ul><li> \$4Q = \$10,000 </li></ul></ul><ul><ul><li> Q = 2500 </li></ul></ul><ul><li>Machine A should be purchased if expected demand is between 1000 and 2500 units per year. </li></ul>
26. 26. Summary: <ul><li>Break-even analysis can be an effective tool in determining the cost effectiveness of a product. </li></ul><ul><li>Required quantities to avoid loss. </li></ul><ul><li>Use as a comparison tool for making a decision. </li></ul>
27. 27. Bibliography: <ul><li>Russel, Roberta S., and Bernard W. Taylor III. Operations Management. Upper Saddle River, NJ: Pentice-Hall, 2000. </li></ul><ul><li>Horngren, Charles T., George Foster, and Srikant M. Datar. Cost Account. 10 th ed. Upper Saddle River, NJ: Pentice-Hall, 2000. </li></ul>