Chapter 13

Breakeven and Payback Analysis

 Breakeven Analysis

• It is performed to determine the value

of a variable that makes two elements
equal, e.g. sales volume that will equate
revenues and cost
• Should use estimates that are
considered to be certain
• Management tool for planning purposes
• Useful for Make-or-Buy decisions
 Payback Analysis

• Used to determine the required

minimum life of an asset to recover the
initial investment
• Used as a screening tool prior to PW,
AW or other analyses

Should not be used as

the final decision maker.
Types of Revenue Relation

R is revenue per yr
Q is no. of units
per yr

Profit = Revenue – Total Cost

 Components of Costs

FC: Fixed Costs, include overhead, etc.

VC: Variable Costs, incl. materials, etc.
TC: Total Cost, TC = FC + VC
 Solving for Breakeven Point

Profit = Revenue – Total Cost

= R – TC
= R – (FC + VC)
To find breakeven point, set R = TC, and let Q
be the decision variable (e.g. quantity).
Also, r: revenue per unit, v: var. cost per unit
R = TC
rQBE = FC + vQBE
 Breakeven Point

rQBE = FC + vQBE
QBE = FC
r-v
When Q > QBE
Then profit is made
Warning:
R and TC are static values.
BE point provides an estimate
mainly for planning purposes.
 Example

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.
Breakeven between Alternatives

For two Mutually Exclusive Alternatives:

1. Define the common variable (e.g. annual
production rate)
2. Develop equivalence PW or AW
relations as function of the common
variable
3. Equate the relations, solve for variable
Breakeven between Alternatives

Selection of
alternative is based on
anticipated value of
common variable
• FCalt 2 > FCalt 1

• VCalt 2 < VCalt 1 (lower slope)

Numerical Solution

Numerical solution can be done by

calculating PW or AW at the MARR:
1. Define the common variable and its
dimensions (e.g. price per unit)
2. Develop the PW or AW relation for each
alternative as a function of the common
variable
3. Equate the two relations and solve for the
breakeven value of the variable
Example
Two machines have following estimates.

Machine 1 2
Initial cost, $ 23,000 8,000
A&O, $/year 3,500 1,500
Salvage, $ 4,000 -
n, years 10 5
Hourly wage, $/hr 12 8
Number of workers 1 3
Production rate, tons/hr 8 6

Use breakeven analysis for AW to select

one machine at MARR = 10%.
For more than two alternatives

When output is less

than 40 units/hour,
select alternative 1

When output is between

40 and 60 units/hour,
select alternative 2

When output is greater

than 60 units/hour,
select alternative 3
 Payback Period Analysis

• Determines the amount of time needed

to recover the initial cost of an asset or
project
• It is another application of PW
technique
• Also known as the payout period
 Payback Period Analysis

It is the estimated amount of time (np)

for cash inflows to recover an initial
investment (P) plus a stated ROI (i%)
Two types of Payback:
1. No-return payback where recovery of
only the initial investment (i = 0%)
2. Discounted payback considers the time
value of money (i > 0%)
 Four Cases
0 1 2 3 4 0 1 2 3 4

Annual Uniform NCF NCFt varies annually

t=n p

No return P 0 = −P + ∑ NCFt
np =
i = 0% NCF t=1

t=n p
Discounted 0 = −P + NCF(P / A, i, n p ) 0 = −P + ∑ NCFt (P / F, i, t)
i > 0% t=1
 Payback Analysis

• If asset life is less than payback

period, then not enough time to recover
the investment
• Payback neglects all cash flows
occurring after the payback period
• May get a different alternative than
PW, AW, ROR, and B/C analyses
• Mostly used to get a sense of risk
involved
 Example

machine 1 machine 2
First cost, $ 12,000 8,000
NCF, $ per year 3,000 1,000 (year 1-5)
3,000 (year 6-
14)
Maximum life 7 yrs 14 yrs
Use:
(a) no-return payback,
(b) discounted payback at 15%, and
(c) PW analysis at 15% to select a system.
 Summary

• Breakeven amount is a point of indifference to accept or

reject a project
• One project breakeven: accept if quantity is > QBE
• Two alternative breakeven: if level > breakeven, select lower
variable cost alternative (smaller slope)
• Payback estimates time to recover investment. Return can
be i = 0% or i > 0%
• Use payback as screening method only because it 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
 Practice Problems

• 13.1 • 13.21
• 13.2 • 13.27
• 13.10 • 13.30
• 13.13 • 13.31
• 13.17 • 13.45
• 13.18 • 13.53