Break

Even
Analysis

1
 Breakeven Analysis
• A method for calibrating the uncertainty
associated with a decision
• Isolates a key unknown variable, usually volume
(quantity) and solves for the value which makes
the decision a toss-up
The ‘answer’ is then evaluated for likelihood of
occurrence
• By comparison to benchmarks & analogies
• By computing implied market share
• By projecting competitive responses
2
 Breakeven Analysis
•If breakeven point is less than likely volume,
proposal is financially attractive (i.e. better to
proceed than not)

•But, an opportunity projected to be above the

breakeven point is not necessarily the best
available option since other opportunities may
offer even more attractive financial returns …
only better than doing nothing
3
4
 Key Financial Variables/models
• Revenue = Quantity x Price
• Profit = Revenue –Total Cost
• Total Cost= Fixed Cost + Variable Cost
• Variable Cost= f(Quantity)
• Contribution = Revenue –Variable Cost
• Breakeven Point= Fixed Cost / Contribution
(Quantity) (Total) (Per Unit)

5
Models of Cost, Revenue, and Profit pg. 14

Quantitative models arising in business and economic

applications involve the relationships of:

• volume variable—such as production volume or sales volume and

• cost, revenue, and profit

From these models, a manager can determine:

• the projected cost, revenue, or profit associated with a
planned production quantity or a forecasted sales volume.
• Financial planning, production planning, sales quotas, and
• other areas of decision making can benefit from such cost,
revenue, and profit models.

6
 Cost and Volume Models pg. 14

Cost of manufacturing or producing a product is a

function of the volume produced.
• Cost = fixed cost + variable cost.
Fixed cost = portion of the total cost that does not
depend on the production volume; this cost
remains the same no matter how much is
produced.
Variable cost = portion of the total cost that
depends on and varies with the production volume.

7
 Fixed Cost
Fixed Cost (FC)
• Are those costs that do not vary with the quantity of output produced.
• For simplicity, typically assumed to be constant across broad volume
ranges
• is the portion of the total cost that does not depend on the production
volume; this cost remains the same no matter how much is produced.
• defined as expenses that do not change as a function of the activity of a
business, within the relevant period.
• Not inventoriable costs

Formula:
Fixed Cost = Total Cost – Variable Cost
Total Fixed cost = Total Cost – Total Variable Cost
Or
Average Fixed Cost x Quantity

8
 Fixed Costs
Here are several examples of fixed costs, indirect costs or overhead:

• Amortization. This is the gradual charging to expense of the cost of an intangible

asset (such as a purchased patent) over the useful life of the asset.
• Depreciation. This is the gradual charging to expense of the cost of a tangible
asset(such as production equipment) over the useful life of the asset.
• Insurance. This is a periodic charge under an insurance contract.
• Interest expense. This is the cost of funds loaned to a business by a lender. This is
only a fixed cost if a fixed interest rate was incorporated into the loan agreement.
• Property taxes. This is a tax charged to a business by the local government, which
is based on the cost of its assets.
• Rent. This is a periodic charge for the use of real estate owned by a landlord.
• Salaries. This is a fixed compensation amount paid to employees, irrespective of
their hours worked.
• Utilities. This is the cost of electricity, gas, phones, and so forth. This cost has a
variable element, but is largely fixed.
• Loan payment

9
 Variable cost
Here are a number of examples of variable costs, all in a production setting:

• Direct materials. The most purely variable cost of all, these are the raw materials that go into a
product.
• Piece rate labor. This is the amount paid to workers for every unit completed (note: direct labor is
frequently not a variable cost, since a minimum number of people are needed to staff the
production area; this makes it a fixed cost).
• Production supplies. Things like machinery oil are consumed based on the amount of machinery
usage, so these costs vary with production volume.
• Billable staff wages. If a company bills out the time of its employees, and those employees are only
paid if they work billable hours, then this is a variable cost. However, if they are paid salaries
(where they are paid no matter how many hours they work), then this is a fixed cost.
• Commissions. Salespeople are paid a commission only if they sell products or services, so this is
clearly a variable cost.
• Credit card fees. Fees are only charged to a business if it accepts credit card purchases from
customers. Only the credit card fees that are a percentage of sales (i.e., not the monthly fixed fee)
should be considered variable.
• Freight out. A business incurs a shipping cost only when it sells and ships out a product. Thus,
freight out can be considered a variable cost.

10
 References
• https://www.accountingtools.com/articles/w
hat-are-examples-of-fixed-costs.html
• https://en.wikipedia.org/wiki/Fixed_cost
• https://strategiccfo.com/variable-vs-fixed-
cost/
• www.investinganswers.com/financial-
dictionary/economics/variable-costs-804
• http://www.investinganswers.com/dictionary/
fixed-costs
11
 Variable costs
Variable Cost Example:
For example, let’s assume that it costs a bakery $15.00 to bake a cake - $5.00
for raw materials such as sugar, milk, and flour, and $10.00 for the direct labor
involved in baking 1 cake. The table below shows how the variable costs change
as the number of cakes baked

1 cake 2 cakes 7 cakes 10 cakes 0 cakes

Cost of sugar,
flour, butter, $5.00 $10.00 $35.00 $50.00 $0.00
and milk
Direct labor $10.00 $20.00 $70.00 $100.00 $0.00
Total variable
$15.00 $30.00 $105.00 $150.00 $0.00
cost

As the production output of cakes increases, the bakery’s variable

costs also increase. When the bakery does not bake any cake, its
variable cost drops to zero.
12
 Fixed and Variable Costs and Decision-Making

• When making production-related decisions should managers consider fixed costs or

only variable costs?
• Generally speaking, variable costs are more relevant to production decisions than
fixed costs.

For example:
• if a manager is deciding between keeping production levels
constant or increasing production;
• the primary factors in this decision will be the variable or incremental costs of
the production of additional units of output,
• not the fixed costs related to the operations that cannot be altered and will not
change with the level of production.

• Therefore, in most straightforward instances, fixed costs are not relevant

for production decision, and incremental costs, or variable costs, are relevant for
these decisions.

13
 Cost and Volume Models
Example: pg. 14
• Nowlin Plastics produces a variety of compact disc (CD)
storage cases. Nowlin’s bestselling product is the CD-
50, a slim plastic CD holder with a specially designed
lining that protects the optical surface of each CD.
Several products are produced on the same
manufacturing line, and a setup cost is incurred each
time a changeover is made for a new product. Suppose
the setup cost for the CD-50 is $3000; this setup cost is
a fixed cost and is incurred regardless of the number of
units eventually produced. In addition, suppose that
variable labor and material costs are $2 for each unit
produced.
14
 Cost and Volume Models
Example: pg. 14
• Nowlin Plastics produces a variety of compact disc (CD)
storage cases. Nowlin’s bestselling product is the CD-
50, a slim plastic CD holder with a specially designed
lining that protects the optical surface of each CD.
Several products are produced on the same
manufacturing line, and a setup cost is incurred each
time a changeover is made for a new product. Suppose
the setup cost for the CD-50 is $3000; this setup cost is
a fixed cost and is incurred regardless of the number of
units eventually produced. In addition, suppose that
variable labor and material costs are $2 for each unit
produced.
15
 Cost and Volume Models
cost–volume model for producing x units of the CD-
50 can be written as
Cost model, Cx
Cx = 3000 + 2(x) eqn. (1.3)
Total Cost= Fixed Cost + Variable Cost
Where:
x = production volume in units
Cx = total cost of producing x units
Ex.: x = 1200 units
How much is the cost?
16
 Cost and Volume Models
Marginal cost = the rate of change of the total cost with respect to
production volume

• the cost increase associated with a one-unit increase in the

production volume.

From our example:

• cost model of equation (1.3),
• the total cost C(x) will increase by $2 for each unit increase in the
production volume
• the marginal cost is $2.
• total cost models, marginal cost may depend on the production
volume.
• marginal cost increases or decreases with the production volume x.

17
 Revenue and Volume Models
• A function of volume (quantity) and price
• the income that a business has from its normal business
activities, usually from the sale of goods and services to
customers.
• referred to as sales or turnover. Some companies
receive revenue from interest, royalties, or other fees.

• For simplicity, price is typically assumed to be constant

across the relevant range of volume

• So, revenue curve is portrayed as linear with a slope equal

to the constant price

18
 Revenue and Volume Models
Example: Nowlin Plastics :
Revenue and selling a specified number of units.

Suppose that each CD-50 storage unit sells for $5.

Model for total revenue:
Revenue = Price x Quantity
Rx = 5(x)

Where:
x = sales volume in units
Rx = total revenue associated with selling x units
19
 Revenue and Volume Models
Example: Nowlin Plastics :
Revenue and selling a specified number of units.
Suppose that each CD-50 storage unit sells for $5.
Model for total revenue:
Rx = 5(x)
Revenue = Price x Quantity eqn. (1.4)
Where:
x = sales volume in units
Rx = total revenue associated with selling x units

Marginal revenue :
the rate of change of total revenue with respect to sales volume, that is,
the increase in total
revenue resulting from a one-unit increase in sales volume.
From the example above in eqn. 1.4 :
• the marginal revenue is $5.
• marginal revenue is constant and does not vary with the sales volume.
• marginal revenue increases or decreases as the sales volume x increases.

20
 Profit and Volume Models
One of the most important criteria for management decision making is PROFIT.
• Managers need to know the profit implications of their decisions.
• If we assume that we will only produce what can be sold, the production volume
and sales volume will be equal.

• Profit -volume model : combination of equation 1.3 + 1.4 : from the models of
the revenue–volume and cost–volume relationships.

• Total profit is total revenue minus total cost …..

Profit = Revenue –Total Cost
Px = Rx – Cx eqn. (1.5)
= price (quantity) – [FC + VC(x)]
= 5x – [ 3000 + 2(x) ]
= – 3000 + 3x
note: x = no. of units sold

21
 Breakeven Analysis
Ex.:
P(x) = Rx – Cx (1.5)
= price(qantity) –[FC + VC(x)]
= 5(x) – [ 3000 + 2(x) ]
= – 3000 + 3x
Ex.: 500 units products sold : x = 500
Px = Rx – Cx
= price(qantity) –[FC + VC(x)]
= 5 (x )– [3000 + 2(x)]
= – 3000 + 3 (500)
= – 1500 (losing)
Ex.: 1800 units products sold : x = 1800
Px = Rx – Cx
= price(qantity) –[FC + VC(x)]
= 5(x) – (3000 + 2 (x) ]
= – 3000 + 3 (1800)
= 2400 (gaining) 22
 Breakeven Point
BREAKEVEN POINT
The volume that results in total revenue equaling total cost
(providing $0 profit).

Valuable information for known breakeven point:

If the breakeven point is known :

volume above the breakeven point is profitable (gaining)
volume below the breakeven point will result in a loss.

23
 Breakeven Point
BREAKEVEN POINT
Using equation (1.5), profit model : the breakeven point can be
compouted.
Ex.: Nowlin Plastics
By setting the profit expression to 0 and solve the production volume for
break even:
Px = Rx – Cx eqn. (1.5)
= price(qantity) –[FC + VC(x)]
= 5 (x) – (3000 + 2x)
= – 3000 + 3x
note: x = no. of units sold
P(x) = 0
0 = – 3000 + 3x
3x = 3000
x = 1000 (breakeven point of then no. of units sold……. 24
 Breakeven Point
BREAKEVEN POINT
Meaning : sales must exceed 1000 units

Figure 1.6 page 16 Shows the graphs of the total cost model, the
total revenue model, and the location of the breakeven point

FIGURE 1.6 GRAPH OF THE BREAKEVEN ANALYSIS FOR NOWLIN

PLASTICS

In Appendix 1.1 we also show how Excel can be used to perform

a breakeven analysis for the Nowlin Plastics production example.

25
 Sample Problem
1. The O’Neill Shoe Manufacturing Company will produce a
special-style shoe if the order size is large enough to provide a
reasonable profit. For each special-style order, the company
incurs a fixed cost of $2000 for the production setup. The
variable cost is $60 per pair, and each pair sells for $80.
a. Let x indicate the number of pairs of shoes produced.
Develop a mathematical model for the total cost of
producing x pairs of shoes.
b. Let P indicate the total profit. Develop a mathematical
model for the total profit realized from an order for x
pairs of shoes.
c. What is the breakeven point?
d. How much the marginal cost?
e. What is the marginal revenue?
26
Key Financial Variables (type of costs)
• Revenue = Quantity x Price
• Profit = Revenue –Total Cost
• Total Cost= Fixed Cost + Variable Cost
• Variable Cost= f(Quantity)
• Contribution = Revenue –Variable Cost
• Breakeven Point= Fixed Cost / Contribution
(Quantity) (Total) (Per Unit)

27
 Revenue
Revenue:

• A function of volume (quantity) and price

• For simplicity, price is typically assumed to be constant across the

relevant range of volume

• So, revenue curve is portrayed as linear with a slope equal to the

constant price

Revenue = Quantity x Price

29
 Breakeven Analysis: Revenue

volume
30
 Fixed Cost
Fixed Cost (FC)
• Are those costs that do not vary with the quantity of output
produced.

• For simplicity, typically assumed to be constant across broad

volume ranges
• is the portion of the total cost that does not depend on the
production volume; this cost remains the same no matter how
much is produced.
Formula:
Fixed Cost = Total Cost – Variable Cost
Total Fixed cost = Total Cost – Total Variable Cost
Or
Average Fixed Cost x Quantity

31
 Breakeven Analysis: Fixed Cost

Fixed cost

volume
32
 Fixed Cost
Example:
• Let's assume it costs Company XYZ $1,000,000 to produce 1,000,000 widgets per year($1 per
widget).

• This $1,000,000 cost includes $500,000 of administrative, insurance, and marketing expenses,
which are generally fixed
.
• If Company XYZ decides to produce 2,000,000 widgets next year, its total production costs may
only rise to $1,500,000 ($0.75 per widget) because it can spread its fixed costs over more units.

• Although Company XYZ's total costs increase from $1,000,000 to $1,500,000, each widget
becomes less expensive to produce and therefore more profitable.

• Some fixed costs change in a stepwise manner as output changes and therefore may not be
totally fixed. Also note that many cost items have both fixed and variable components. For
example, management salaries typically do not vary with the number of units produced.
However, if production falls dramatically or reaches zero, layoffs may occur. Economically, all
costs are variable in the end.

33
 Fixed Cost
• A business is sometimes deliberately structured to have a
higher proportion of fixed costs than variable costs, so that
it generates more profit per unit produced.
• This concept only generates outsized profits after all fixed
costs for a period have been offset by sales.

Example:
a software development company has a fixed cost
requirement of $500,000 per month and essentially no cost
per unit sold, so revenues of $400,000 per month will
generate a loss of $100,000, but revenues of $600,000 will
generate a profit of $100,000. See the cost-volume-
profit analysis for more information.

34
 Variable Cost
Variable Cost (VC)
• Are those costs that do vary with the quantity of output produced.
• For simplicity, typically assumed to be constant on a per unit basis.
• So, the variable cost curve is linear with slope equal to the variable
cost per unit.
• is the portion of the total cost that depends on and varies with the
production volume.

Formula:
Total Variable Cost = total Cost – Total Fixed Cost
Or
Average Variable Cost x Quantity

35
 Breakeven Analysis: Variable Cost

Variable cost

volume
36
 Below is an example of a firm's cost schedule and a graph of the fixed and
variable costs. Noticed that the fixed cost curve is flat and the variable cost
curve has a constant upward slope.

37
 Variable Cost
Variable Cost is:

• Total Variable Cost = Total Quantity of Output x Variable Cost Per Unit of Output
• The term variable cost is not to be confused with variable costing, which is an accounting method
related to reporting variable costs.
• HOW IT WORKS (EXAMPLE):
• Let's assume XYZ Company has received an order for 5,000 widgets for a total sales price of $5,000
and wants to determine the gross profit that will be generated by completing the order. First, the
variable costs per widget must be determined.
• Let's assume the following:
• Annual Widgets Produced: 100,000
Raw Materials Costs: $10,000
Direct Labor Costs: $50,000
• From this information, we can conclude that each widget costs 10 cents ($10,000 / 100,000
widgets) in raw materials and 50 cents ($50,000 / 100,000 widgets) in direct labor costs. Using the
formula above, we can calculate that XYZ Company's total variable cost on the order is:
• 5,000 x ($0.10 + $0.50) = $3,000
• Therefore, the company can reasonably expect to earn a $2,000 gross profit ($5,000 - $3,000) from
the order.

38
 Breakeven Point

• The quantity at which revenue equals total

cost

• Also, the point at which contribution equals

fixed costs

39
 Breakeven Analysis

Variable cost

Fixed cost

volume
40
 Problems
2. Micromedia offers computer training seminars on a variety of topics. In the
seminars each student works at a personal computer, practicing the particular
activity that the instructor
is presenting. Micromedia is currently planning a two-day seminar on the use
of Microsoft Excel in statistical analysis. The projected fee for the seminar is
$600 per student. The cost
for the conference room, instructor compensation, lab assistants, and
promotion is $9600. Micromedia rents computers for its seminars at a cost of
$60 per computer per day.
a. Develop a model for the total cost to put on the seminar. Let x represent
the number of students who enroll in the seminar.
b. Develop a model for the total profit if x students enroll in the seminar.
c. Micromedia has forecasted an enrollment of 30 students for the seminar.
How much profit will be earned if its forecast is accurate?
d. Compute the breakeven point.

41
 Problems
3. Eastman Publishing Company is considering publishing a paperback
textbook on spreadsheet applications for business. The fixed cost of
manuscript preparation, textbook design,
and production setup is estimated to be $160,000. Variable production and
material costs are estimated to be $6 per book. Demand over the life of the
book is estimated to be 4000 copies.
The publisher plans to sell the text to college and university bookstores for
$46 each.
a. What is the breakeven point?
b. What profit or loss can be anticipated with a demand of 3500 copies?
c. With a demand of 3500 copies, what is the minimum price per copy that
the publisher must charge to break even?
d. If the publisher believes that the price per copy could be increased to
$50.95 and not affect the anticipated demand of 4000 copies, what action
would you recommend? What profit or loss can be anticipated?

42
 Problems
4. Preliminary plans are underway for construction of a new stadium for a
major league baseball team. City officials question the number and
profitability of the luxury corporate boxes
planned for the upper deck of the stadium. Corporations and selected
individuals may purchase a box for $300,000. The fixed construction cost for
the upper-deck area is estimated
to be $4,500,000, with a variable cost of $150,000 for each box constructed.
a. What is the breakeven point for the number of luxury boxes in the new
stadium?
b. Preliminary drawings for the stadium show that space is available for the
construction
of up to 50 luxury boxes. Promoters indicate that buyers are available and
that all 50
could be sold if constructed. What is your recommendation concerning the
construction
of luxury boxes? What profit is anticipated?

43
 Total Cost
Total Cost (TC)
The market value of the inputs a firm uses in
production.
Formula:
Total Cost = Total Fixed Cost + Total Variable Cost
Or
Total Cost = Average Cost x Quantity

44
 Average Cost
Average Cost
Can be determined by dividing the firm’s costs by
the quantity of output it produces.
Formula:
Average Cost = Average Fixed Cost + Average
Variable Cost
Or
Total Cost
Average Cost = -------------------------
Quantity
45
 Average Fixed Cost
Average Fixed Cost (AFC)
This is a fixed cost per unit of out put.
AFC steadily decreases as more of a good is
produced.
Formula:
Total Fixed Cost
Average Fixed Cost = --------------------------
Quantity

46
 Average Variable Cost
Average variable cost (AVC)
This is the variable cost per unit of output.
AVC will decrease, reach a minimum and then
increase as more of a good is produced. The curved
is U-shaped.
Formula:

Total Variable Cost

Average Variable Cost = ---------------------------
Quantity
47
 Marginal Cost
Marginal Cost (MC)
• Cost producing one extra unit of output.
• the rate of change of the total cost with respect to
production volume; that is, the cost increase
associated with a one-unit increase in the production
volume.
Formula:

Change in Total Cost

MC = ---------------------------------
Change in Quantity

48
 Opportunity Cost
Opportunity cost
the value of the next best alternative that must
be sacrificed when one makes a choice.

49
 Activity
Output, Total Total Total Average Average Average Marginal
quantity Fixed Variable Cost Fixed Variable (total) Cost
(O) Cost Cost N$ Cost Cost Cost N$
N$ N$ N$ N$ N$
0 50
3 88
4 100
9 150
10 158
16 200
17 205

50
 Break Even Analysis
Formula:
(Fixed Cost)
Break Even Point = ----------------------------
(Contribution per unit)

Where:
Contribution = Selling cost – Variable Cost
Fixed Cost = Contribution = Profit

51
Application of Break-Even Analysis in
Market Conditions
Fixed Cost
Monthly Rental 100
Insurance (600/year: 50
600/12=50
Total Monthly Fixed Cost 150

Variable Cost
Materials 3
Labor 4
Total Variable Cost 7

Selling Price 10
52
 Break-Even Point Calculation
Fixed Cost
Break-Even Point = ------------------------------------
(Selling Cost-Variable Cost)
= 150 / (10 – 7)
= 50
Meaning:
To Break-Even , the company must sell 50 units
per month.

53
 Break-Even Point Calculation
If the Company just broke-even, then its Profit and Loss Statement is:

Monthly Profit and Lost Statement:

Sales
Gross Sales (10 per unit x 50 units) 300
Less Cost of Goods Sold (7 per unit x 50 units) 350
Net Sales 150

Expenses:
Rent 100
Insurance 50
Total Expenses 150

Net Profit 0

54
55
 Activity 2
• Mountain view is a small, romantic bed and breakfast hotel
located near Grahamstown, The charge of R500 per double
room is for one night’s accomodation excluding breakfast.
(Patrons can walk across the road to an independent coffee
shop for a delicious breakfast). The retired couple who own
and manage the hotel estimate that the variable cost per
room is 200 dollar per day. This includes cost such as
electricity, laundry, cleaning and utilities. The hotel’s fixed
cost , which includes council rates, water rates and land
taxes, total of R420,000 per year. The hotel has 10 double
rooms. The hotel charges per room and a couple sharing a
room will pay the same rate as a single person per room.

56
 Activity 2
Required:
Contribution margin per unit of service
(a unit service is one night’s accommodation
per room)
Contribution margin ratio
Annual break-even point in units of service and in Rands
of service revenue

The number of units of service required to earn a target

net profit of R600,000 for the year (ignore income tax)

57
• https://www.slideshare.net/BalajiP6/research-
proposal-38164461
• https://www.wiley.com/en-
us/Quantitative+Methods%3A+An+Introduction+for+B
usiness+Management-p-9780470496343
• https://www.youtube.com/watch?v=iDdSlN19o_g
• https://www.slideshare.net/PallaviKurra/compartment
-modelling
• http://slideplayer.com/slide/10696360/
• http://slideplayer.com/slide/9354145/

58