Chapter 8

Breakeven
and Payback
Analysis
Lecture slides to accompany

Engineering Economy
7th edi4on

Leland Blank
Anthony Tarquin

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LEARNING OUTCOMES

1.  Breakeven point – one parameter

2.  Breakeven point – two alternatives
3.  Payback period analysis

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BREAKEVEN POINT
Value of a parameter that makes two elements equal
The parameter (or variable) can be an amount of
revenue, cost, supply, demand, etc. for one project
or between two alternatives
q One project - Breakeven point is identified as QBE.
Determined using linear or non-linear math relations
for revenue and cost
q Between two alternatives - Determine one of the
parameters P, A, F, i, or n with others constant
Solution is by one of three methods:
Ø Direct solution of relations
Ø Trial and error
Ø Spreadsheet functions or tools (Goal Seek or
Solver)

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COST-REVENUE MODEL ― ONE PROJECT
Quantity, Q — An amount of the variable in
question, e.g., units/year, hours/month
Breakeven value is QBE

Fixed cost, FC — Costs not directly dependent on the variable, e.g.,

buildings, fixed overhead, insurance, minimum workforce cost
Variable cost, VC — Costs that change with parameters such as
production level and workforce size. These are labor, material
and marketing costs. Variable cost per unit is v
Total cost, TC — Sum of fixed and variable costs, TC = FC + VC

Revenue, R — Amount is Profit, P — Amount of

dependent on quantity sold revenue remaining after costs
Revenue per unit is r P = R – TC = R – (FC+VC)
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 BREAKEVEN FOR LINEAR R AND TC
Set R = TC and solve for Q =
QBE

R = TC
rQ = FC + vQ

FC
QBE =
r – v


When variable cost, v, is
lowered, QBE decreases
(moves to le?)

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EXAMPLE 1: ONE PROJECT BREAKEVEN POINT
A plant produces 15,000 units/month. Find breakeven level if
FC = $75,000 /month, revenue is $8/unit and variable cost is
$2.50/unit. Determine expected monthly profit or loss.

Solu4on: Find QBE and compare to 15,000; calculate Profit

QBE = 75,000 / (8.00-2.50) = 13,636 units/month

Produc4on level is above breakeven Profit

Profit = R – (FC + VC)

= rQ – (FC + vQ) = (r-v)Q – FC
= (8.00 – 2.50)(15,000) – 75,000
= $ 7500/month

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EXAMPLE 2
Indira Industries is a major producer of diverter dampers used in the gas turbine
power industry to divert gas exhausts from the turbine to a side stack, thus
reducing the noise to acceptable levels for human environments. Normal
production level is 60 diverter systems per month, but due to significantly
improved economic conditions in Asia, production is at 72 per month. The
following information is available.
Fixed costs
FC = $2.4 million per month
Variable cost per unit
v = $35,000
- Revenue per unit
r= $75,000
(a) What is the current profit level per month for the facility?
(c) What is the revenue per unit cost per damper that is necessary if the
production level significantly reduced to 45 units. Note : the fixed costs is
remaining constant.

7
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BREAKEVEN BETWEEN TWO ALTERNATIVES
To determine value of common variable between 2 alternatives, do
the following:
1.  Define the common variable
2.  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:

ü  Value BELOW breakeven;

select higher variable cost

ü  Value ABOVE breakeven;

select lower variable cost

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 EXAMPLE: TWO ALTERNATIVE
BREAKEVEN ANALYSIS
Perform a make/buy analysis where the
common variable is X, the number of units
produced each year. AW rela4ons are: Breakeven
AW, 1000 value of X
$/year
AWmake = -18,000(A/P,15%,6) 8 AWbuy

+2,000(A/F,15%,6) – 0.4X 7
AWmake
6
AWbuy = -1.5X
5

4
Solu4on: Equate AW rela4ons, solve for X

-1.5X = -4528 - 0.4X 3

2
X = 4116 per year
1
If anticipated production > 4116,
0
select make alternative (lower variable
1 2 3 4 5
cost)
X, 1000 units per year
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EXAMPLE 3: MAKE OR BUY
Guardian is a national manufacturing company of home health care appliances. It is faced with a make-or-buy
decision. A newly engineered lift can be installed in a car trunk to raise and lower a wheelchair. The steel arm of
the lift can be purchased internationally for $3.50 per unit or made in-house. If manufactured on site, two
machines will be required. Machine A is estimated to cost $18,000, have a life of 6 years, and have a $2000
salvage value; machine B will cost $12,000, have a life of 4 years, and have a $ 500 salvage value (carry-away
cost). Ma- chine A will require an overhaul after 3 years costing $3000. The annual operating cost for machine A
is expected to be $6000 per year and for machine B is $5000 per year. A total of four operators will be required
for the two machines at a rate of $12.50 per hour per operator. In a normal 8-hour period, the operators and two
machines can produce parts sufficient to manufacture 1000 units. Use a MARR of 15% per year to determine the
following.
(a) Number of units to manufacture each year to justify the in-house (make) option.
(b) The maximum capital expense justifiable to purchase machine A, assuming all other estimates
for machines A and B are as stated. The company expects to produce 10,000 units per year.

10
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a) Use steps 1 to 3 stated previously to determine the breakeven point.
1.Define x as the number of lifts produced per year.
2. There are variable costs for the operators and fixed costs for the two machines for the
make option.
Annual VC=cost per unit x unit per year
4 operators $12.50
= ————— x ——— (8 hours)x
1000 units hour
= 0.4x

The annual fixed costs for machines A and B are the AW amounts.
AWA =18,000(A P,15%,6) + 2000(A F,15%,6) - 6000 - 3000(P F,15%,3)(A P,15%,6)
AWB = - 12,000(A P,15%,4) - 500(A F,15%,4) - 5000

Total cost is the sum of AWA, AWB, and VC.

3. Equating the annual costs of the buy option (3.50x) and the make option yields
- 3.50x = AWA +AWB - VC
= 18,000(A P,15%,6) +2000(A F,15%,6) - 6000 -3000(P F,15%,3)(A P,15%,6) - 12,000(A P,15%,4) - 500(A F,15%,4) – 5000 - 0.4x
- 3.10x= - 20,352
x = 6565 units per year

b) Substitute 10,000 for x and PA for the to-be-determined first cost of machine A (currently $18,000) in Equation [13.5]. Solution
yields PA $58,295. This is approximately three times the estimated first cost of $18,000, because the production of 10,000 per year is
considerably larger than the breakeven amount of 6565.

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 BREAKEVEN ANALYSIS USING GOAL
SEEK TOOL
Spreadsheet tool Goal Seek finds breakeven value for the
common variable between two alterna4ves
Problem: Two machines (1 and 2) have following estimates.
a) Use spreadsheet and AW analysis to select one at MARR =
10%.
b) Use Goal Seek to find the breakeven first cost.

Machine 1 2
P, $ -80,000 -110,000
NCF, $/year 25,000 22,000
S, $ 2,000 3,000
n, years 4 6

Solu\on: a) Select machine A with AWA = $193

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BREAKEVEN ANALYSIS USING GOAL SEEK TOOL
Solu4on: b) Goal Seek finds a first-cost breakeven of $96,669 to
make machine B economically equivalent to A

Changing
cell

Spreadsheet after Goal Seek is

applied
Target
cell
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PAYBACK PERIOD ANALYSIS
Payback period: Estimated amount of time (np) for cash inflows to
recover an
initial investment (P) plus a stated return of return
(i%)

Types of payback analysis: No-return and discounted

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

Cau4on: Payback period analysis is a good ini4al screening

tool, rather than the primary method to jus4fy a project or
select an alterna4ve (Discussed later)

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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

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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 are expected to be positive.

• Approach of payback analysis is different from PW,

AW, ROR and B/C analysis. A different alternative may
be selected using payback.
• 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

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EXAMPLE: PAYBACK ANALYSIS
System 1 System 2
First cost, $ 12,000
8,000
NCF, $ 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.
Comment
on the results.

Solution: (a) Use Eqns. 1 and 2

np1 = 12,000 / 3,000 = 4 years
np2 =13-14
-8,000 + 5(1,000) + 1(3,000) =
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EXAMPLE: PAYBACK ANALYSIS
(CONTINUED)
System 1 System 2
First cost, $ 12,000 8,000
NCF, $ 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 4

System 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 = $663
PW2 = $2470
Select system 2
Comment: PW method considers cash flows after payback
period. Selection changes from system
1 to 2 13-15
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SUMMARY OF IMPORTANT POINTS
Breakeven amount is a point of indifference to
accept or reject a project
One project breakeven: accept if quan8ty is > QBE

Two alterna4ve breakeven: if level > breakeven,

select lower variable cost alterna4ve (smaller slope)

Payback es4mates 4me to recover investment.

Return can be i = 0% or i > 0%
Use payback as supplemental to PW or other analyses,
because np neglects cash flows after payback,
and if i = 0%, it neglects time value of money
Payback is useful to sense the economic risk in a project
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