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Engineering Economics Lecture Sheet - 4 CVP

The document discusses concepts related to break-even analysis including: - Computing break-even points using units and sales dollars - Calculating contribution margin ratios - Applications of break-even analysis such as pricing, profit planning, and decision making - Limitations of break-even analysis including assumptions about fixed costs and external factors - Additional concepts of marginal cost and how it is used to optimize production costs

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33 views41 pages

Engineering Economics Lecture Sheet - 4 CVP

The document discusses concepts related to break-even analysis including: - Computing break-even points using units and sales dollars - Calculating contribution margin ratios - Applications of break-even analysis such as pricing, profit planning, and decision making - Limitations of break-even analysis including assumptions about fixed costs and external factors - Additional concepts of marginal cost and how it is used to optimize production costs

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ebrahimbutex
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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(Break even analysis)

or Break Even
(Break Even Analysis)
(Break even analysis)
(Break even analysis)
(Break even analysis)
(Break even analysis)
(Break even analysis)
Example 1 :
H & M wants to produce a new jacket and has
forecast the following information(Currency BDT):
Selling price per jacket = 800
variable cost per jacket = 300
fixed costs related to jacket production = 55,00,000
target profit = 2,00,000

Find out the quantity of jackets needed for the target


profit.
Ans:
Break-Even Point
The break-even point is a financial
metric that measures the level of
sales at which the total revenue
equals the total cost. It is the point
where the company neither makes a
profit nor incurs a loss.
Computing the break-
even point in unit sales
and sales dollars
Profits = (Sales – Variable expenses) – Fixed expenses

OR

Sales = Variable expenses + Fixed expenses + Profits

At the break-even point


profits equal zero
Example 2

Suppose, here is the information from Groz-Beckert Company:

Total Per Unit


Sales (500 Socks Knitting m/c) $ 250,000 $ 500
variable expenses (500 Socks Knitting m/c) $ 150,000 $ 300

fixed expenses 80,000

calculate the break-even point


● We calculate the break-even point as follows:
Sales
Sales == Variable
Variable expenses
expenses ++ Fixed
Fixed expenses
expenses ++ Profits
Profits

$500Q = $300Q + $80,000 + $0

Where:
Q = Number of Socks Knitting Machine
sold
$500 = Unit selling price
$300 = Unit variable expense
$80,000 = Total fixed expense
Therefore,
$500Q = $300Q + $80,000 + $0

or, $200Q = $80,000


Q = $80,000 ÷ $200 per Socks Knitting Machine
Q = 400 Socks Knitting Machines
Contribution Margin Ratio (CM Ratio)

The contribution margin ratio is a financial metric that measures


the percentage of revenue that remains after all variable costs
have been deducted from the revenue. It represents the marginal
benefit of producing one more unit.
The higher the margin, the better. The higher the company's ratio
result, the more money it has available to cover the company's
fixed costs or overhead. It helps us understand the profitability of
new products.

The formula for calculating the contribution margin ratio is:


Example 3 :
Zara wants to produce a new hoodie and has forecast
the following information (Currency BDT):
Selling price per hoodie = 800
variable cost per hoodie = 300

estimated sales = 12,000 hoodies

Find out the Contribution Margin Ratio of hoodies


Answer:
Total revenue = Selling price per hoodie x estimated sales
= 800 x 12000
= 9600000

Total variable cost = variable cost per hoodie x estimated sales


= 300 x 12000
= 3600000
Application of break-even analysis
Some of the applications of break-even analysis are:
1. Pricing strategy: Break-even analysis can help us
decide the optimal price for the product or service that
will maximize the profit margin and sales volume.
2. Profit planning: Break-even analysis is a financial tool
that helps us determine at which stage the company,
service or product will be profitable. It is a financial
calculation used to determine the number of products or
services a company must sell to cover its expenses.
3. Decision making: Break-even analysis can help us
evaluate the feasibility and profitability of different
business scenarios, such as launching a new product,
expanding production capacity, or entering a new market.
Application of break-even analysis
(contd.)
4. Risk analysis: Break-even analysis can help us
measure the sensitivity of the profit to changes in various
factors, such as cost, price, demand, or competition. It
can also help us calculate the margin of safety, which is
the amount of sales above the break-even point that can
absorb any unexpected decrease in sales.

5. Modernization or automation decisions: Analysis of the


profit in implication of a modernization or automation
program.
Limitations of Break-Even Analysis
Break-even analysis is a useful tool. However, like any tool, there
are limitations to it.
• Break-even analysis assumes that the fixed and variable costs
remain constant over time. In reality, this is usually not the
case. Costs may change due to factors such as inflation,
changes in technology, or changes in market conditions.
• Another limitation is that Break-even analysis makes some
oversimplified assumptions about the relationships between
costs, revenue, and production levels. For example, it assumes
that there is a linear relationship between costs and
production. This is not always true.
• Also, break-even analysis ignores external factors such as
competition, market demand, and changing consumer
preferences, which can have a significant impact on a
business.
Marginal cost
Marginal cost is the incremental cost of
producing one more unit of a good or service.
It is calculated by taking the change in total
costs and dividing by the change in quantity of
units produced. Marginal cost helps optimize
production and profit.
Some key points about marginal cost:
• Marginal cost includes all costs that vary with
the level of production, such as labor and
materials, but not fixed costs, such as rent and
machinery.

• Fixed costs are constant regardless of


production levels, so higher production leads to
a lower fixed cost per unit as the total is
allocated over more units.

• Variable costs change based on production


levels, so producing more units will add more
variable costs.
Marginal Cost Formula

Marginal cost is calculated as the total expenses


required to manufacture one additional good.

Marginal Cost =
Example of Marginal Cost :
Here is an example of how to calculate marginal cost:
Big Dynamo is a company that produces robot toys.
Every month, they produce 2,000 robot toys for a total
cost of $200,000. They expect to produce 4,000 robot
toys next month for $250,000.
Marginal Cost
Current production amount 2000
Current production cost $200,000
Future production amount 4000
Future cost of production $250,000
Marginal Cost Formula $25
Example of Marginal Cost :

Since we know that Marginal Cost = (Change in Total Cost)/


(Change in Quantity),

Change in total cost = (250,000-$200,000) = $50,000

Change in total units = (4000-2000) = 2000

So, the marginal cost equals $50,000/2000 = $25

The marginal cost represents the change in the cost of a good,


not the total cost of the good itself. This $25 represents the
margin change.
Example 4:
A company makes hats.
Each hat produced requires $0.75 of plastic and fabric.
The hat factory also incurs $1,000 dollars of fixed costs per
month.
The hat factory machinery can only produce 1,499 hats per
month.
cost of adding an additional machine is $500.
Calculate marginal cost for producing 500 hats per month, 1,000
hats per month and 1,500 hats per month.
Solution:
If we make 500 hats per month, then fixed costs per hat will be
$1,000 / 500 = $2
Plastic and fabric costs are variable costs.
So, total cost per hat would be = $2 fixed cost per unit + $0.75
variable costs)= $2.75

If we make 1,000 hats per month, then fixed costs per hat will
be
$1,000 / 1,000 = $1
Fixed costs are spread out over an increased number of units of
output.
So, total cost per hat would be = $1 fixed cost per unit + $0.75
variable costs)= $1.75
In this situation, increasing production volume causes marginal
costs to go down.
If we make 1,500 hats per month, the hat factory will be
unable to handle any more units of production on the
current machinery. The machinery could only handle
1,499 units. The 1,500th unit would require purchasing an
additional $500 machine. In this case, the cost of new
machine will be added in the marginal cost of production
calculation. In this situation, increasing production
volume causes marginal costs to increase.

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