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Breakeven Analysis
Breakeven Analysis
Breakeven Analysis
Breakeven analysis (cost-volume-profit analysis): approach to profit planning that requires derivation of various relationships among revenue, fixed costs, and variable costs in order to determine units of production or volume of sales dollars at which firm breaks even (where total revenues equal total of fixed and variable costs)
Breakeven Applications
Four major applications:
1. 2. 3. 4. New product decisions Pricing decisions Modernization or automation decisions. Expansion decisions.
Breakeven Applications
1. New product decisions
Determine sales volume required for firm (or individual product) to break even, given expected sales and expected costs
2. Pricing decisions
Study the effect of changing price and volume relationships on total profits
Breakeven Analysis
3. Modernization or automation decisions
Analyze profit implications of a modernization or automation program
In this case, firm substitutes fixed costs (i.e. capital equipment costs) for variable costs (i.e. direct labor)
4. Expansion decisions
Study aggregate effect of general expansion in production and sales
In this case, relationships between total dollar dales for all products and total dollar costs for all products are examined in order to indentify potential changes in these relationships
Fixed costs estimate: $1,650 Variable costs estimate: $350 Selling price per package:$500
Once enough units sold to cover fixed costs (11 units), each unit then makes direct contribution to profits. Once above breakeven point, relatively small percentage increase in number of units sold will produce relatively large percentage increase in profit.
$500X = $1,650 + $350X + $3,000 $150X = $4,650 X = 31 units Porter must sell 31 units, or $15,500 worth of suspensions ($500 x 31 = $15,500).
Breakeven Charts
See exhibit 8.1 for graphic representation of breakeven problem posed by Peter Porters Porsche Plant
1. Illustrates key assumptions of breakeven analysis
Revenue and total cost are treated as simple linear functions of number of units produced and sold. Profit or loss is difference between revenue and total cost. Breakeven point occurs where revenue equals total cost.
Breakeven Charts
Exhibit 8.1 (continued)
2. Provides simple visual interpretation of effect of changing cost-volume-profit relationships
Incurring additional fixed costs shifts horizontal fixed-cost line upward, thus raising total-cost line parallel to itself and causing breakeven point to rise. Substitute additional fixed costs (i.e. additional depreciation for improved capital equipment) for low levels of variable cost (i.e. less direct labor and material waste):
Horizontal fixed-cost line moves upward, but total-cost line becomes less steep due to lower levels of variable cost Higher breakeven level and higher contribution margin (revenue per unit less variable cost per unit) At levels of operation sufficiently above breakeven point, profits are much higher, while near or below breakeven, profits are less or losses are greater.
Breakeven Charts
Exhibit 8.1 (continued)
2. (continued)
Porter buys additional capital equipment to produce racing suspensions, causing annual fixed costs to rise to $1,920. Variable costs per unit decline to $340. New contribution margin is $160 per unit New breakeven point:
Revenue = Fixed costs + Variable costs $500X = $1,920 + $340X $160X = $1,920 X = 12 units
Breakeven Charts
See exhibit 8.2 At new level of operation, breakeven point is one unit higher than old level.
At high levels of operation (30 units), profits under new cost-volume-profit relationships are $2,880 (compared to $2,850 under old relationships) At lower levels, (20 units), profits for new system are $1,280 (compared to $1,350 for old system) At loss levels (5 units), new relationships produce loss of $1,120 (compared to $900 under old relationships) An increase in level of fixed costs must be justified by expectation of level of operations substantially in excess of breakeven level.
Breakeven Charts
Determine point at which new relationships produce same profit as old relationships.
R FC VC = R FC VC $500X - $1,650 - $350X = $500X - $1,920 - $340X $270 = $10X X = 27 units At 27 units of production, profits are same under either alternative.
Under first alternative: Profit = ($500) (27) - $1,650 ($350) (27) = $2,400 Under revised alternative: Profit = ($500) (27) - $1,920 - ($340) (27) = $2,400
Breakeven Charts
See exhibit 8.3: profit as function of units produced and sold is graphed for each alternative
Above 27 units, second alternative will produce larger profits than first alternative. Below 27 units, first alternative will produce higher profits (in profit zone) or lower losses (in loss zone) than second alternative.
See exhibit 8.4 Total cost function for wide ranges of output looks like a curve
Total cost curve increases at decreasing rate over some range and then begins to increase at increasing rate.
Revenue function more nearly resembles a curve than a straight line over wide ranges of output.
If sales volume continues to expand over very wide range, sales price per unit must eventually decline in order to achieve everincreasing sales.
Developing equation for curves is almost impossible, but can be ignored for practical purposes.