Chapter Five

Breakeven and Payback Analysis

Breakeven analysis is performed to determine the value of a parameter of a project or

alternative that makes two elements equal, for example, the sales volume that will equate
revenues and costs. A breakeven study is performed for two alternatives to determine when
either alternative is equally acceptable. Breakeven analysis is commonly applied in make-
or-buy decisions when a decision is needed about the source for manufactured components,
services, etc.
Payback analysis determines the required minimum life of an asset, process, or system to
recover the initial investment. There are two types of payback: return (i > 0%) and no return
(i = 0%). Payback analysis should not be considered the final decision maker; it is used as a
screening tool or to provide supplemental information for a PW, AW, or other analysis.

5.1 Breakeven Analysis for a Single Project

Breakeven analysis finds the value of a parameter that makes two elements equal. The
breakeven point QBE is determined from mathematical relations, for example, product
revenue and costs or materials supply and demand or other parameters that involve the
parameter Q. Breakeven analysis is fundamental to evaluations such as make-buy
decisions.
 Figure 5 –1a presents different shapes of a revenue relation identified as R. A linear
revenue relation is commonly assumed, but a nonlinear relation is often more realistic. It
can model an increasing per unit revenue with larger volumes (curve 1 in Figure 5 –1a) or a
decreasing per unit revenue that usually prevails at higher quantities (curve 2).
Costs, which may be linear or nonlinear, usually include two components fixed and
variable as indicated in Figure 5–1b.
Fixed costs (FC). These include costs such as buildings, insurance, fixed overhead, some
minimum level of labor, equipment capital recovery, and information systems.
Variable costs (VC). These include costs such as direct labor, materials, indirect costs,
contractors, marketing, advertisement, and warranty.
When FC and VC are added, they form the total cost relation TC. Figure 5–1b illustrates
the TC relation for linear fixed and variable costs. Figure 5 –1c shows a general TC curve for
a nonlinear VC in which unit variable costs decrease as the quantity level rises. At a specific
but unknown value Q of the decision variable, the revenue R and total cost TC relations will
intersect to identify the breakeven point QBE (Figure 5–2).
As a general guideline, for linear R and VC relations, the greater the quantity, the larger the
profit. A simple relation for the breakeven point may be derived when revenue and total cost
are linear functions of quantity Q by setting the relations for R and TC equal to each other,
indicating a profit of zero.
rQ = FC + vQ
where r = revenue per unit
v = variable cost per unit
Solve for the breakeven quantity Q = QBE for linear R and TC functions

FC
Q BE  5-1
(r  v)
The profit at any quantity level Q is:

Profit = revenue − total cost

= R − (FC + VC)
= rQ − FC − vQ
= (r – v)Q – FC 5.2

If Q > QBE, there is a profit; if Q < QBE, there is a loss.

 Example 5-1:

Indira Industries is a major producer of diverter dampers used in the gas turbine power
industry to divert gas exhausts from the turbine to a side stack, thus reducing the noise
to acceptable levels for human environments. Normal production level is 60 diverter
systems per month, but due to significantly improved economic conditions in Asia,
production is at 72 per month. The following information is available.
Fixed costs FC = 2.4 million per month
Variable cost per unit v = 35,000
Revenue per unit r = 75,000

a. How does the increased production level of 72 units per month compare with
the current breakeven point?
b. What is the current profit level per month for the facility?
c. What is the difference between the revenue and variable cost per damper that
is necessary to breakeven at a significantly reduced monthly production level
of 45 units, if fixed costs remain constant?
Solution:
a)
The breakeven number of units is:
QBE = [ FC / ( r – v ) ] = [ 2400 / ( 75 – 35 ) ] = 60 units per month

Figure 5–3 is a plot of R and TC lines. The breakeven value is 60 damper units. The
Increased production level of 72 units is above the breakeven value.
b)
To estimate profit (in L.D 1000 units) at Q = 72 units per month,
Profit = (r − v)Q − FC [5.3]
= (75 − 35)72 – 2400 = 480
There is a profit of 480,000 per month currently.
(c)
To determine the required difference r − v, when profit = 0, Q = 45, and FC = 2.4 million.
In 1000 units,
0 = (r − v) (45) − 2400
r − v = 2400 / 45 = 53.33 per unit

The difference between r and v must be 53,330. If v stays at 35,000, the revenue per damper
must increase from 75,000 to 88,330 (i.e., 35,000 + 53,330) just to break even at a
production level of Q = 45 per month.

In some circumstances, breakeven analysis performed on a per unit basis is more

meaningful. The value of QBE is still calculated using Equation [4.1]; however, the
relations for R and TC are divided by Q. In the case of TC, the expression for cost per
unit, also termed average cost per unit Cu, is:
TC FC  vQ FC
Cu    v 5-4
Q Q Q
5.2 Breakeven Analysis for Two Projects

Breakeven analysis determines the value of a common variable or parameter between two
alternatives. Equating the two PW or AW relations determines the breakeven point.
Selection of the alternative is different depending upon two facts: slope of the variable
cost curve and the parameter value relative to the breakeven point.
The following steps determine the breakeven point of the common variable and the slope of
a linear total cost relation:
1. Define the common variable and its dimensional units.
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.

Selection between alternatives is based on this guideline:

If the anticipated level of the common variable is below the breakeven

value, select the alternative with the higher variable cost (larger slope). If the
level is above the breakeven point, select the alternative with the lower
variable cost. (Refer to Figure 5–4.)
Example 5-2:
Devon Products produces a superior quality, high-gloss, nonskid surface concrete stone
primarily used as flooring in kitchens and baths. The equipment necessary to complete the
nonskid surface operations can be a fully automated or semiautomatic machine. The fully
automated machine has an initial cost of L.D 23,000, an estimated salvage value of L.D 4000,
and a predicted life of 10 years. One person will operate the machine at a total cost of L.D 40
per hour. The expected output is 8 tons per hour. Annual maintenance and operating cost is
expected to be L.D 3500. The semiautomatic machine has a first cost of L.D 8000, no
expected salvage value, a 5-year life, and an output of 10 tons per hour; however, an operator
with additional skills is required at the rate of L.D 60 per hour.
 The machine will have an annual maintenance and operation cost of L.D 1500. All
projects are expected to generate a return of 10% per year. How many tons of finished
stone per year must be produced to justify the higher purchase cost of the fully automatic
machine?
Solution:

Fully Automated M/C Semiautomatic M/C (B)

(A)
Initial Cost -23,000 -8,000
Salvage value 4000 -----
Annual VC -(40/8)Q -(60/10)Q
Annual M&O cost -3,500 -1,500
Interest rate 10% 10%
Life per year 10 5

Q = number of tons per year

For Automated M/C ( A )

AWA = -23,000 ( A/P 10,10 ) – 3,500 – 5Q + 4,000(A/F 10,10 )

= -23,000(0.1628) – 3,500 – 5Q + 4,000(0.0628) = -6992 – 5Q
For Semiautomatic M/C (B )

AWB = -8,000 ( A/P 10,5 ) – 1,500 – 6Q

= -8,000(0.26328) – 1,500 – 6Q = -3610 – 6Q

AWA = AWB
-6992 – 5Q = -3610 – 6Q
Then Q = 6992 – 3610 = 3382 tons

If the output is expected to exceed 3382 tons per year, purchase the fully automatic
machine, since its VC slope of 5 is smaller than the semiautomatic VC slope of 6.
Example 5-3:

Guardian is a national manufacturing company of home health care appliances. It is faced

with a make-or-buy decision. A newly engineered lift can be installed in a car trunk to
raise and lower a wheelchair. The steel arm of the lift can be purchased for L.D 0.60 per
unit or made inhouse. If manufactured on site, two machines will be required. Machine A
is estimated to cost L.D 18,000, have a life of 6 years, and a L.D 2000 salvage value;
machine B will cost L.D 12,000, have a life of 4 years, and a L.D -500 salvage value
(carry-away cost). Machine A will require an overhaul after 3 years costing L.D 3000.
The AOC for A is expected to be L.D 6000 per year and for B L.D 5000 per year. A total
of four operators will be required for the two machines at a rate of L.D 12.50 per hour
per operator. 1,000 units will be manufactured in a normal 8-hour period. Use an MARR
of 15% per year to determine the following:
a. Number of units to manufacture each year to justify the inhouse (make) option.
b. The maximum capital expense justifiable to purchase machine A, assuming all other
estimates for machines A and B are as stated. The company expects to produce 125,000
units per year.
Solution:
a.
• Define Q as the number of lifts produced per year.
• There are variable costs for the operators and fixed costs for the two machines for the
make option.
Annual VC = ( Cost per unit ) ( Units per year )
= [( 4 /1000 ) ( 12.5 * 8 ) Q = 0.4 Q

M/C (A) M/C (B)

Initial Cost -18,000 -12,000
Salvage value 2000 -5,00
Overhaul after 3 years -3,000 ----
Annual M&O cost -6,000 -5,000
MARR 15% 15%
Life per year 6 4

The annual fixed costs for machines A and B are the AW amounts.

AWA = -18,000(A/P,15%,6) + 2000(A/F,15%,6) - 6000 - 3000(P/F,15%,3) (A/P,15%,6)

= -18,000(0.2642) + 2000 (0.1142) – 6000 – 3000(0.4323)(0.2642) = -10,870
 AWB = -12,000(A/P,15%,4) - 500(A/F,15%,4) - 5000
= -12,000(0.3503) – 500(0.2003) – 5000 = -9304

Total cost is the sum of AWA, AWB, and VC.

The annual costs of the buy option (0.60Q) and the make option yields

-0.6Q = AWA + AWB + VC

-0.6Q = -10,870 – 9304 – 0.4Q
Q = 20174 / 0.2 = 100,870

A minimum of 100,870 lifts must be produced each year to justify the make option,
which has the lower variable cost of 0.40Q
b)
The production level is above breakeven. To find the maximum justifiable PA, substitute
125,000 for Q and PA for the first cost of machine A.

-0.6(125,000) = -PA (0.2642) - 6114 – 9304 – 0.4(125,000)

PA = ( 75,000 – 65,418 ) / (0.2642) = 36,268

Solution yields PA = L.D 36,268. This means that approximately twice the estimated first
cost of L.D 18,000 could be spent on A.
5.3 Payback Analysis

Payback analysis is another use of the present worth technique. It is used to determine the
amount of time, usually expressed in years, required to recover the first cost of an asset or
project. Payback is allied with breakeven analysis. The payback period, also called
payback or payout period, has the following definition and types.
 The payback period np is an estimated time for the revenues, savings, and any other
monetary benefits to completely recover the initial investment plus a stated rate of
return i. There are two types of payback analysis as determined by the required return.
 No return; i = 0%: Also called simple payback, this is the recovery of only the initial
investment with no interest.
 Discounted payback; i > 0%: The time value of money is considered in that some return,
for example, 10% per year, must be realized in addition to recovering the initial
investment.
To calculate the payback period for i = 0% or i > 0%, determine the pattern of the net cash
flow ( NCF ) series. Note that np is usually not an integer. For t = 1, 2, . . . , np .
NCF = cash inflow – cash outflow 5-4
np
No return, i = 0%; NCF t varies annually: 0   P 
 NCF
t 1
t

P
No return, i = 0%; annual uniform NCF: n p 
NCF
np
Discounted, i > 0%; NCFt varies annually: 0   P   NCFt ( P / Fi, t )
t 1

Discounted, i > 0%; annual uniform NCF: 0 = -P + NCF(P/A, i, n p)

Example 5-4:
The board of directors of Halliburton International has just approved an L.D 18
million worldwide engineering construction design contract. The services are
expected to generate new annual net cash flows of L.D 3 million. The contract has a
potentially lucrative repayment clause to Halliburton of L.D 3 million at any time
that the contract is canceled by either party during the 10 years of the contract
period. (a) If i = 15%, compute the payback period. (b) Determine the no-return
payback period and compare it with the answer for i = 15%. This is an initial check
to determine if the board made a good economic decision.

Solution
0 = -P + NCF(P/A, 15, np) + 3 (P/F, 15, np )
If np = 10
0 = - 18 + 3( 5.0188 ) + 3( 0.2472 ) = -2.202 < 0
If np = 17
0 = - 18 + 3( 6.0472 ) + 3( 0.0929 ) = 0.4203 > 0

By interpolation np = 15.3, then during the period of 10 years, the contract

will not deliver the required return.
 b)
No – return i = 0 , applying equation :

np
0   P   NCFt  18  3(n p )  3
t 1

np = 15 / 3 = 5 years

There is a very significant difference in np for 15% and 0%. At 15% this contract
would have to be in force for 15.3 years, while the no-return payback period requires
only 5 years. A longer time is always required for i > 0% for the obvious reason that the
time value of money is considered.
Notice:
If two or more alternatives are evaluated using payback periods to indicate that one may
be better than the other(s), the second shortcoming of payback analysis (neglect of cash
flows after np ) may lead to an economically incorrect decision. When cash flows that
occur after np are neglected, it is possible to favor short-lived assets even when longer-
lived assets produce a higher return. In these cases, PW (or AW) analysis should always be
the primary selection method.
Example 5-5:

Two equivalent pieces of quality inspection equipment are being considered for purchase
by Square D Electric. Machine 2 is expected to be versatile and technologically advanced
enough to provide net income longer than machine 1.

M/C -1 M/C-2

First cost -12,000 -8,000

Annual NCF 3,000 1000 (1-5) year
3000( 6-14) year
Maximum life, years 7 14

The quality manager used a return of 15% per year. Determine which machine the quality
manager preferred.
Solution:
For M/C -1 :
If I np = 7

0 = -P + NCF(P/A, 15, 7) = -12,000 + 3000(4.1604) = 481.2 > 0

If I np = 6
0 = -P + NCF(P/A, 15, 6) = -12,000 + 3000(3.7845) = -646.5 < 0
By interpolation np = 6.57 years

For M/C -2 :

If I np = 14
0 = -8,000 + 1000(P/A, 15, 5) + 3000(P/A, 15, 14-5)(P/F, 15 , 5)
= -8,000 + 1000(3.3522) + 3000 ( 4.7716 )(0.4972) = > 0

If I np = 9
0 = -8,000 + 1000(P/A, 15, 5) + 3000(P/A, 15, 9-5)(P/F, 15 , 5)
= -8,000 + 1000(3.3522) + 3000 ( 2.8550 )(0.4972) = < 0

By interpolation np = 9.52 years

Recommendation: Select machine 1.
Now, use a 15% PW analysis to compare the machines and comment on any difference
in the recommendation.

PW1 = -12,000 + 3000(P/A,15%,14) – 12,000 ( P/F 15%, 7 ) = 663

PW2 = -8000 + 1000(P/A,15%,5) + 3000(P/A,15%,9)(P/F,15%,5) = 2470

Machine 2 is selected since its PW value is numerically larger than that of machine 1 at
15%. This result is the opposite of the payback period decision. The PW analysis accounts
for the increased cash flows for machine 2 in the later years. payback analysis neglects all
cash flow amounts that may occur after the payback time has been reached.