BREAK-EVEN ANALYSIS

INTRODUCTION

It is a set of planning tools which can be, and has been, very useful in managing
organizations. One significant indication of the performance of a company is reflected by
the so-called bottom line of the income statement for the firm; that is, how much profit is
earned! Break-even analysis focuses upon the profitability of a firm. Of specific concern
in break-even analysis is identifying the level of operation or level of output that would
result in a zero profit. This level of operations or output is called the break-even point.
The break-even point is a useful reference point in the sense that it represents the level of
operation at which total revenue equals total cost. Any changes from this level of
operation will result in either a profit or a loss.

Break-even analysis is valuable particularly as a planning tool when firms are

contemplating expansions such as offering new products or services. Similarly, it is
useful in evaluating the pros and cons of beginning a new business venture. In each
instance the analysis allows for a projection of profitability.

Assumptions

Since there exist both linear and non-linear break even situations we will focus only
upon situations in which both the total cost function and the total revenue function are
linear. The use of a linear total cost function implies that variable costs per unit either are
constant or can be assumed to be constant. The linear cost function assumes that total
variable costs depend upon the level of operation or output. It is also assumed that the
fixed-cost portion of the cost function is constant over the level of operation or output
being considered.

The linear total revenue function assumes that the selling price per unit is constant.
Where the selling price is not constant, average price is sometimes chosen for purposes of
conducting the analysis.

Another assumption is that price per unit is greater than variable cost per unit. Think
about that for a moment. If price per unit is less than variable cost per unit, a firm will
lose money on every unit produced and sold. A break-even condition could never exist.

Break-Even Analysis

In break-even analysis the primary objective is to determine the break-even point. The
break-even point may be expressed in terms of (1) volume of output (or level of activity),
(2) total dollar sales, or possibly (3)percentage of production capacity. For example, it
might be stated that a firm will break even at 100,000 units of output, when total sales
equal $2.5 million or when the firm is operating at 60 percent of its plant capacity. We
will focus primarily on the first of these three ways.

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 The methods of performing break-even analysis are rather straightforward, and
thee are alternative ways of determining the break-even point. The usual approach is as
follows:

1. Formulate total cost as a function of x, the level of output.

2. Formulate total revenue as a function of x.
3. Since break-even conditions exist when total revenue equals total cost, set C(x)
equal to R(x) and solve for x. The resulting value of x is the break-even level of
output and might be denoted by xBE.
An alternative to step 3 is to construct the profit function P(x) = R(x) – C(x), set P(x)
equal to zero, and solve for xBE.

Example 1

A group of engineers is interested in forming a company to produce smoke detectors.

They have developed a design estimate that variable costs per unit, including materials,
labor, and marketing cost, are $22.50. Fixed costs associated with the formation,
operation, and management of the company and the purchase of equipment machinery
total $250,000.
They estimate that the selling price will be $30 per detector.
(a) Determine the number of smoke detectors which must be sold in order for the
firm to break-even on the venture.
(b) Preliminary marketing data indicate that the firm can expect to sell approximately
30,000 smoke detectors over the life of the project if the detectors are sold $30 per
unit.
Determine expected profits at this level of output.

SOLUTION

(a) If x equals the number of smoke detectors produced and sold, the total revenue
function is represented by the question

R(x) = 30x

The total cost function is represented by the equation

C(x) = 22.50x + 250,000

The break-even condition occurs when total revenue equals total cost, or when
R(x) = C(x)

For this problem the break-even point is computed as

30x = 22.50x + 250,000

Or 7.50x =250,000

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And xBE = 33,333.33 units

The alternative approach is first to write the profit function and set it equal to
zero, as follows:
P(x) = R(x) – C(x)
= 30x – (22.50x + 250,000)
= 7.50x – 250,000
Setting the profit function P equal to 0, we have

7.50x -250,000 =0
7.50x =250,000
Or xBE = 33,333.33 units
This is the same result, and our conclusion is that given the assumed cost and price
parameters (values), the firm must sell 33,333.33 units in order to break-even.

(b) With sales projected at 30,000 smoke detectors.

P(30,000) = 7.5 (30,000) – 250,000

= 225,000 – 250,000 = - 25,000

This suggests that if all estimates-price, cost, and demand-hold true, the firm can expect
to lose $25,000 on the venture.

EXAMPLE 2

A large Engineering consultancy group has 30 full-time engineers. Currently, all billing
of clients is done manually by clerks. Because of the heavy volume of billing the business
manager believes it is time to convert from manual to computerized billing. Two options
are being considered: (1) the group can lease its own computer and software and do the
billing itself or (2) the group can contract with a computer service bureau which will do
the billing.

The costs of each alternative are a function of the number of client bills. The lowest bid
submitted by a service bureau would result in an annual flat fee of $3,000 plus $0.95 per
bill processed. With the help of a computer consultant, the business manager has
estimated that the group can lease a small business computer system and the required
software at a cost of $15,000 per year. Variable costs of doing the billing in this manner
are estimated at $0.65 per bill.

If x the number of bills per year, the annual billing cost using a service bureau is
represented by the function

S(x) = 3,000 + 0.95x

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 The annual cost of leasing a computer system and doing the billing in-house is expressed
by the function
L(x) = 15,000 + 0.65x

These two alternatives are equally costly when

S(x) = L(x)
Or 3,000 + 0.95x = 15,000 + 0.65x
0.30x = 12,000
x = 40,000
Thus, if the expected number of bills per year exceeds 40,000, the lease options is the

)
au
ure
eb e)
70,000 v ic eas
r (L
(Se .6 5x
Minimum cost alternative at 95x 0 +0
Ann 60,000 0. 5 00
ual given level of billing 0
+ =1
0 x)
30 L(
cost x)
=
of 50,000 S(
billin
g 40,000

30,000

20,000

10,000

10,000 20,000 30,000 40,000 50,000 60,000 70,000

Number of bills per year

less costly. If the number of bills is expected to be less than 40,000, the service bureau
option is the less costly. Figure above illustrates the two cost functions.

EXAMPLE 3

Three Alternatives) Suppose in the previous example that the business manager is not
convinced that computer processing is the most cost-effective means of handling billing.
He estimates that processing bills manually costs the group practice $1.25 per bill, or

M(x) = 1.25x

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 If this method is considered as a third option, let’s examine the implications. The three
cost functions are graphed together in Fig. below If you study this figure carefully, you
should reach the following conclusions:

)
70,000 au
u re
eb
v ic
er
60,000 (S
Ann Minimum cost alternative at 9 5x ase
)
l) 0. x (Le
ual given level of billing ua + 0.6
5
an 00 00
+
cost 50,000 30 150
(M = )=
of
x x) L(x
25 S(
1.
billin 40,000 =
)
g (x
M
30,000

20,000

10,000

10,000 20,000 30,000 40,000 50,000 60,000 70,000

Number of bills per year

1. The least costly option at any level of bills is highlighted by the heavy line
segments.
2. If the number of bills per year is expected to be less than 10,000, the manual
system is the least costly.
3. If the number of bills is expected to be between 10,000 and 40,000 the service
bureau arrangement is the least costly.
4. If the number is expected to exceed 40,000 the lease arrangement is the least
costly.

SENSITIVITY ANALYSIS

In many cases simple break even analysis is not feasible because several factors may vary
simultaneously as the single variable is varied. In such instances it is helpful to determine
how sensitive is the situation to the several variables so that proper weight may be
assigned to them. In general sensitivity analysis is used to analyze the effects of changes
or making errors in estimating parameter values. Because the parameters used in
mathematical models are frequently estimates, actual results may differ from those
projected by the mathematical analysis. To account for some of the uncertainties which

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may exist in a problem, analyst often conduct sensitivity analysis. The objective is to
assess how much a solution might change if there are changes in model parameters.

In short sensitivity analysis permits a determination of how sensitive the final results are
to changes in the values of the estimates.

PRACTICE EXAMPLE

Let us consider the refiner who wants to determine the total cost of producing Q barrels
of gasoline per day, which is given by:

TC = 4,000 + 2Q

and the total revenue (in thousands of dollars) from selling Q barrels of gasoline per day
is expressed by:

TR = 4Q

The value of $4.00 in the TR equation is the price of selling a barrel of gasoline. In most
instances the price is not known with certainty. Let us assume that $4.00 is the most
likely price and there is a pessimistic price of $3.00 and another price of $5.00, which is
considered to be optimistic.
Solution
The break-even quantities under the pessimistic, the most likely and the optimistic prices
are shown in Table below:
Sensitivity Analysis Table

Pessimistic Most likely Optimistic

Break-even 4,000 2,000 1,333

Conclusion
The use of the three price estimates results in providing three different estimates for the
break even quantities. Three estimates for parameters other than the price could also be
considered to provide sensitivity analysis for the quantity or other parameters such as
total cost or total revenue.