DR. FILEMON C.

AGUILAR MEMORIAL COLLEGE OF LAS PIÑAS

Golden Gate Subd., Talon III, Las Piñas City

Course Code and Title: ACED 4 – MANAGERIAL ECONOMICS

Lesson Number: 3 – Breakeven and Price Changes

Topic:

I. INTRODUCTION

In this lesson the students will learn the use of table, graphs and algebraic functions in the study of
breakeven, price changes and marginal analysis in decision making.
 DR. FILEMON C. AGUILAR MEMORIAL COLLEGE OF LAS PIÑAS
Golden Gate Subd., Talon III, Las Piñas City

II. OBJECTIVES:

At the end of the lesson, the student should be able to:

1. Calculate the relationships between breakeven, effect of price changes and marginal analysis;
2. Follow the steps in computing the breakeven, effect of price changes and marginal analysis in
decision making; and
3. Solve problems about the breakeven, effect of price changes and marginal analysis in decision
making..

III. PRE ASSESSMENT:

Calculate the Revenue, Cost and Break Even sales
It costs a publishing company 50,000 dollars to make books. The 50,000 is a fixed cost or a cost that
cannot change. To help the publishing company sell the books, a marketing company charges 4 dollars
for each book sold. If the company charges 9 dollars per book, how many books should they sell to break
even?

IV. PRESENTATION

1. Breakeven Analysis
A scan of Figure 2.1 "Graphs of Revenue, Cost, and Profit Functions for Ice Cream Bar Business at Price
of $1.50" shows that the ice cream bar venture could result in an economic profit or loss depending on
the volume of business. As the sales volume increases, revenue and cost increase and profit becomes
progressively less negative, turns positive, and then becomes increasingly positive. There is a zone of
lower volume levels where economic costs exceed revenues and a zone on the higher volume levels
where revenues exceed economic costs.

One important consideration for our three students is whether they are confident that the sales volume
will be high enough to fall in the range of positive economic profits. The volume level that separates the
 DR. FILEMON C. AGUILAR MEMORIAL COLLEGE OF LAS PIÑAS
Golden Gate Subd., Talon III, Las Piñas City

range with economic loss from the range with economic profit is called the breakeven point. From
the graph we can see the breakeven point is slightly less than 35,000 units. If the students can sell above
that level, which the prior operator did, it will be worthwhile to proceed with the venture. If they are
doubtful of reaching that level, they should abandon the venture now, even if that means losing their
nonrefundable deposit.

There are a number of ways to determine a precise value for the breakeven level algebraically.
First is to solve for the value of Q that makes the economic profit function equal to zero (π = 0):
π = R – C; 0 = $1.2 Q − $40,000 or Q = $40,000/$1.2 = 33,333 units.

Second is to find the value of Q where the revenue function and cost function have identical values.
R = C substitute the values of R & C we have $1.5Q = $40,000 + $0.3Q, solve for Q
$1.5Q - $0.3Q = $40,000; $1.2Q = $40,000; Q = $40,000 / $1.2 = 33,333 units

Third is to assess the breakeven point is to find how large the volume must be before the average cost
drops to the price level. In this case, we need to find the value of Q where AC is equal to $1.50. This
occurs at the breakeven level calculated earlier.
BE is AC = P = $1.5; where AC = $0.3 + $40,000 / Q
$1.5 = $0.3 + 40,000/Q then solve for Q;
$1.2 = 40,000 / Q = Q = $40,000 / $1.2 = 33,333 units

A fourth approach to solving for the breakeven level is to consider how profit changes as the volume level
increases. Each additional item sold incurs a variable cost per unit of $0.30 and is sold for a price of
$1.50. The difference, called the unit contribution margin UCM, would be $1.20. For each additional
unit of volume, the profit increases by $1.20. In order to make an overall economic profit, the business
would need to accrue a sufficient number of unit contribution margins to cover the economic fixed cost of
$40,000. So the breakeven level would be
Q = fixed cost/(price per unit − variable cost per unit) = $40,000/($1.50 − $0.30) = 33,333.3 or 33,333
units.
 DR. FILEMON C. AGUILAR MEMORIAL COLLEGE OF LAS PIÑAS
Golden Gate Subd., Talon III, Las Piñas City

Once the operating volume crosses the breakeven threshold, each additional unit contribution margin
results in additional profit.
 
We get an interesting insight into the nature of a business by comparing the unit contribution margin with
the price. In the case of the ice cream business, the unit contribution margin is 80% ($1.2/$1.5) of the
price. When the price and unit contribution margins are close, most of the revenue generated from
additional sales turns into profit once you get above the breakeven level. However, if you fall
below the breakeven level, the loss will grow equally dramatically as the volume level drops.
Businesses like software providers, which tend have mostly fixed costs, see a close correlation between
revenue and profit. Businesses of this type tend to be high risk and high reward.
 
On the other hand, businesses that have predominantly variable costs, such as a retail grocery outlet,
tend to have relatively modest changes in profit relative to changes in revenue. If business level falls off,
they can scale down their variable costs and profit will not decline so much. At the same time, large
increases in volume levels beyond the breakeven level can achieve only modest profit gains because
most of the additional revenue is offset by additional variable costs.

2. The Impact of Price Changes

In the preceding analyses of the ice cream venture, we assumed ice cream bars would be priced at $1.50
per unit based on the price that was charged in the previous summer. The students can change the
price and should evaluate whether there is a better price for them to charge. However, if the price
is lowered, the breakeven level will increase and if the price is raised, the breakeven level will
drop, but then so may the customer demand.

To examine the impact of price and determine a best price, we need to estimate the relationship
between the price charged and the maximum unit quantity that could be sold. This relationship is
called a demand curve. Demand curves generally follow a pattern called the law of demand, whereby
 DR. FILEMON C. AGUILAR MEMORIAL COLLEGE OF LAS PIÑAS
Golden Gate Subd., Talon III, Las Piñas City

increases in price result in decreases in the maximum quantity that can be sold.

We will consider a simple demand curve for the ice cream venture. We will assume that since the
operator of the business last year sold 36,000 units at a price of $1.50 that we could sell up to 36,000
units at the same price this coming summer. Next, suppose the students had asked the prior operator
how many ice cream bars he believes he would have sold at a price of $2.00 and the prior operator
responds that he probably would have sold 10,000 fewer ice cream bars. In other words, he estimates his
sales would have been 26,000 at a price of $2.00 per ice cream bar.

To develop a demand curve from the prior operator’s estimates, the students assume that the
relationship between price and quantity is linear, meaning that the change in quantity will be
proportional to the change in price. Graphically, you can infer this relationship by plotting the two price-
quantity pairs on a graph and connecting them with a straight line. Using intermediate algebra, you can
derive an equation for the linear demand curve.

Situation 1: P1 = $1.5, Q1 = 36,000; Situation 2: P2 = $2, Q2 = 26,000

Get the slope m = P2 – P1 / Q2 – Q1 = 2 – 1.5 / 26,000 – 36,000 = .5 / – 10,000 = – .00005
Using the slope formula Y = mX + b; substituting the values of any of the situations.
Let us use Situation 2: P = Y = $2, Q = X = 26,000, substituting to slope formula:
2 = –.00005(26,000) + b; 2 = – 1.3 + b; 2 + 1.3; b = 3.3.

Substituting to the slope formula:

P = - .00005Q + 3.3 or P = 3.3 − 0.00005 Q,

where P is price in dollars and Q is the maximum number of ice cream bars that will sell at this price.
Figure 2.3 "Linear Demand Curve for Ice Cream Bar Venture" presents a graph of the demand curve.

Figure 2.3 Linear Demand Curve for Ice Cream Bar Venture
 DR. FILEMON C. AGUILAR MEMORIAL COLLEGE OF LAS PIÑAS
Golden Gate Subd., Talon III, Las Piñas City

It may seem awkward to express the demand curve in a manner that you use the quantity Q to solve for
the price P. After all, in a fixed price market, the seller decides a price and the buyers respond with the
volume of demand. Mathematically, the relationship for ice cream bars could be written (solve for Q)
P = – .00005Q + 3.3; .00005Q = 3.3 – P; Q = (3.3 / .00005) – (P / .00005)
Q = 66,000 − 20,000 P.

However, in economics, the common practice is to describe the demand curve as the highest price P that
could be charged and still sell a quantity Q.

The linear demand curve in Figure 2.3 "Linear Demand Curve for Ice Cream Bar Venture" probably
stretches credibility as you move to points where either the price is zero or demand is zero. In actuality,
demand curves are usually curved such that demand will get very high as the price approaches
 DR. FILEMON C. AGUILAR MEMORIAL COLLEGE OF LAS PIÑAS
Golden Gate Subd., Talon III, Las Piñas City

zero and small amounts would still sell at very high prices, similar to the pattern in Figure 2.4
"Common Pattern for Demand Curves". However, linear demand curves can be reasonably good
estimates of behavior if they are used within limited zone of possible prices.

Figure 2.4 Common Pattern for Demand Curves

We can use the stated relationship in the demand curve to examine the impact of price changes on the
revenue and profit functions. (The cost function is unaffected by the demand curve.) Again, with a single
type of product or service, revenue is equal to price times quantity. By using the expression for price in
terms of quantity rather than a fixed price, we can find the resulting revenue function

P = 3.3 − 0.00005 Q
R = P Q = (3.3 − 0.00005 Q) Q = 3.3 Q − 0.00005 Q2
 DR. FILEMON C. AGUILAR MEMORIAL COLLEGE OF LAS PIÑAS
Golden Gate Subd., Talon III, Las Piñas City

By subtracting the expression for the cost function from the revenue function, we get the revised profit
function

π = R – C = (3.3 Q − 0.00005 Q2) − (40,000 + $0.3 Q) = – 0.00005 Q2 + 3 Q − 40,000

Graphs for the revised revenue, cost, and profit functions appear in Figure 2.5 "Graphs of Revenue, Cost,
and Profit Functions for Ice Cream Bar Venture for Linear Demand Curve". Note that the revenue and
profit functions are curved since they are quadratic functions. From the graph of the profit function, it can
be seen that it is possible to earn an economic profit with a quantity as low as 20,000 units; however, the
price would need to be increased according to the demand curve for this profit to materialize. Additionally,
it appears a higher profit is possible than at the previously planned operation of 36,000 units at a price of
$1.50. The highest profitability appears to be at a volume of about 30,000 units.

The presumed price at this volume based on the demand curve would be around $1.80.

Figure 2.5 Graphs of Revenue, Cost, and Profit Functions for Ice Cream Bar Venture for Linear Demand
Curve
 DR. FILEMON C. AGUILAR MEMORIAL COLLEGE OF LAS PIÑAS
Golden Gate Subd., Talon III, Las Piñas City

V. APPLICATION / EVALUATION – Ice Cream Summer Business

Compute for the blank boxes in the table using the formula for P, Q, R, C and π functions

VI. ASSIGNMENT

1. How do you compute for Marginal Revenue? Marginal Cost? Marginal Profit?
2. Explain the impact of Shutdown Rule.
3. What is the Theory of Consumer Behavior?

VII. REFERENCES
 DR. FILEMON C. AGUILAR MEMORIAL COLLEGE OF LAS PIÑAS
Golden Gate Subd., Talon III, Las Piñas City

AITS-TPT (2018. Introduction to Microeconomics. https://aits-tpt.edu.in/wp-

content/uploads/2018/08/Introduction-to-Managerial-Economics.pdf

Creative Commons (2012). Managerial Economics Principles.

https://2012books.lardbucket.org/pdfs/managerial-economics-principles.pdf

Investopedia (2021). Law of Diminishing Marginal Returns

https://www.investopedia.com/terms/l/lawofdiminishingmarginalreturn.asp

Investopedia (2021). Sunken Cost. https://www.investopedia.com/terms/s/sunkcost.asp

McGuigan, J. R., Moyer, R C., & Harris, F. H. deB. (2017). Managerial Economics Applications, Strategy
and Tactics, Cengage Learning