NED University of Engineering and Technology

APPLIED ECONOMICS FOR ENGINEERS

TOPIC # 5

BREAK EVEN ANALYSES

Learning Outcome:

Concept of Breakeven Analysis (BEA)

Behavior of Costs & Revenue

Numerical and graphical presentations

Practical Applications

BEA as a Management Tool

This chapter covers the basics of break-even analysis which is the simplest analytical
tool in management. It details what break-even analysis is, what it is used for, what
definitions are used in break-even analysis and how break-even analysis can be helpful
in decision-making of professionals in construction industry. In construction industry,
break-even analysis can be a handy tool to find answers to questions such as:
How many years should I operate the facility to recover the initial investment
and annual operating costs?
How much does our company need to sell to reach the desired profitability?
What should be the better option between alternatives?
An enterprise, whether or not a profit maximizing organization, always wants to know:
What price or output level must be for total revenue to just equal to total cost?
The answer is: a breakeven analysis.
Strictly speaking, this analysis is to determine the minimum level of output that allows
the firm to break even, but it could be used to compare and analyze various project
options and alternatives.
Break Even Means: neither profit nor loss; also: a financial result reflecting neither
profit nor loss
Break-even Point: The origins of break-even point can be found in the economic
concepts of the point of indifference. In simple words, the break-even point can be
defined as a point where total costs (expenses) and total sales (revenue) are equal. In
simple words it can be described as a point where there is no net profit or loss. The
firm just breaks even. Another way to look at it is that the break-even point is the
point at which your product stops costing you money to produce and sell, and starts
to generate a profit for your company.

Break-Even Analysis: In its simplest form, it facilitates an insight into the fact
whether the revenue from a project, service or product incorporates the ability to
cover the relevant production cost of that particular project, product or service or not.
On the surface, break-even analysis is a tool to calculate at what production volume the
variable and fixed costs of producing your product will be recovered. Break-even
analysis can also be used to solve other management problems, including setting
prices, and evaluating the best strategies to follow.
Break-even analysis is done by using a parameter (or variable) which is an amount of
revenue, cost, supply, demand, etc. for 1) one project or between 2) two alternatives.

BREAKEVEN ANALYSIS FOR A SINGLE PROJECT

Basically, break-even analysis determines the break-even point, at which operations
neither make money nor lose money (Paek 2000, Blank and Tarquin 2008). At the break-even
point, there is no gain or loss; hence costs or expenses are equal to revenues/incomes.
Costs and Revenue: As far as costs and revenue are concerned we have already
discussed them in detail in previous lectures. Here is only a memory refresher.
Q or QBE
Quantity or Breakeven Quantity
P or AR
Price or Average Revenue
TFC
Total Fixed Cost (Costs that do not change in short-term)
v
Variable Cost per Unit of production or sale

TVC

Total Variable Cost(v.QBE)

VC
TC
TR

Variable Cost
Total Cost (FC + VC)
Total Revenue (P.QBE)

Fixed cost represents the expenses that are not related with the volume of production
(or activity level) over a feasible range of operations. Examples include buildings,
insurance expenses, depreciation, overheads, and cost of information systems (Blank
and Tarquin 2008). It is the sum of all costs to produce the first unit of a product.
Another example could be the cost of excavation equipment regardless of the
excavation work performed on different projects.
Variable cost represents the cost items that change with the volume of production or
construction. Input materials and time to produce a unit affect variable costs.
Examples include direct labor costs, fuel costs, material types (e.g., a certain type of
paint used for painting a facility), and marketing costs (Blank and Tarquin 2008, Paek 2000).
Total cost is the sum of the fixed and total variable costs for any production or
construction.
Total revenue is the product of expected unit sales and the unit price of each unit.

Cost/expense and revenue/income relations are commonly assumed as linear; however

non-linear relations are more realistic with more revenue for larger volumes (Blank and
Tarquin 2008). Here we will confine our discussion only to linear relationship.
Below is given the algebraic expression and explanation through which breakeven
point is identified as QBE which is determined using linear math relations for revenue
and cost.
Mathematically, the formula for break-even point can be shown as:
TR = TC or Profit = 0
Where TR represents the total revenues and TC represents total costs or expenses for
an operation.
TR = TC
Expected unit sales (Q) x Unit price (P) = Fixed cost (FC) + Total variable cost (VC)
Q x P = FC +Variable unit cost (v) x Unit sales(Q)
Q x P = FC + (v x Q)
(Q x P) (v x Q) = FC
Q (P - v) = FC
Q = FC / (P - v)
Let QBE denote the break-even output. The difference P - v is often called the average
contribution margin (ACM) because it represents the portion of selling price that
"contributes" to paying the fixed costs.
Relationship between FC, TC, TR and QEB
Cost/Revenue
TR
Profit
TC
TVC

TFC
Quantity
QBE
Table below shows the summary of effect on QBE

Variable
Total Fixed Cost
(e.g., cost of
equipment)
Average Variable
Cost
(e.g., cost of material)
Product Price

Direction of
Change
Up
Down

Break-even
Output
Up
Down

Up
Down

Up
Down

Up
Down

Down
Up

The break-even diagram can be employed to see the effects of various exogenous
changes on the break-even point. Here are a few scenarios
Initial Change

Curve Affected

Increase in Output price

The TR curve
counterclockwise

Increase in the price of one the

variable input

TVC and TC curves,

both counterclockwise
TFC curve,
parallel-shift up

Higher TFC

moves

Affect on QBE
Decrease
Increase
Increase

Effects of TFC, AVC, and P on QBE

Cost/Revenue
TR1

TR

TR
TC
VC
FC

TC1

TC

VC

FC

Quantity
QBE

Example 1: Assume that as an investor, you are planning to enter the construction
industry as a panel formwork supplier. Given the size of the construction industry and
the potential number of forthcoming projects, you forecasted that within two years,
your fixed cost for producing formworks is Rs. 3,000,000. The variable unit cost for
making one panel is Rs. 1500. The sale price for each panel you charge will be Rs.
2,500. How many panels you need to sell in total, in order to start making money?

Solution:
Variable unit cost = Rs. 1,500/panel
Total fixed cost = Rs. 3,000,000
Price per unit = Rs. 2,500
TC = TR
VC + FC = TR
1,500 x QBE + 3,000 000 = QBE x 2,500 (QBE refers to the number of panels)
QBE = 3,000 000 / (2,500-1,500) = 3,000 panels
Example 2: Calculate the break-even output for FC = $20,000, P = $7, and AVC = $5
Solution:
QBE =

= 10,000

Example 3: A manufacturing company supplies its products to construction job sites.

The average monthly fixed cost per site is $ 4500, while each unit costs $ 35 to
produce, and selling price is $ 50.
a) Determine the monthly volume of supplies to job sites in order to break-even.
b) The company has to modify the selling prices due to severe competition. In this
case, the fixed cost and production costs will be the same, but the sales price
per unit will be $ 50 for the first 200 units and $ 40 for all above this threshold
level. Determine the monthly breakeven volume.
Solution:
(a) Q = 4500 / (50-35) = 300 units, where Q refers to the number of units per month
(b) At 200 units, the profits is negative at -$ 1500, as determined by
Profit = Revenue cost
Profit at 200 units production = 200x50 (4500 + 35x200)
= 10 000 4500- 7000 = -1500.
50 x 200 + 40 x Q = 4500 + 35x (200 + Q)
QBE = (4500 + 7000 -10 000) / (40 35) = 1500 / 5 = 300 units per month
Hence the required volume is 500 units per month, the point at which revenue and
total cost break even at $ 22 000
Example 4: Suppose TFC = $10,000, P = $5, AVC = $2. What is the output necessary to
earn $5000 total profit? What is the average contribution margin?
Answer:
QBE =

= 5,000

Example 5: Suppose that product price decreases from P1 to P2. Show on the diagram
how much output would change to maintain the same level of profit target

Cost/Revenue
TR

TR1
TC

Profit

FC
Quantity
QBE

QBE

Answer: Draw a line parallel to TC through A. This line cuts the TR1 line at B, drop a
vertical line from B to determine the new output level. [Note: The solution may not be
feasible if we are told that the market size cannot accommodate this quantity.]
Example 6: Given TR and TC, a firm is currently operating at 50% of its capacity at
some profit target. How much of a price drop would cause the firm to operate at 75%
capacity at the same level of profit?
Answer:
Cost/Revenue
TR1

TR
TC1

TC

FC
Quantity
QBE

Answer: The vertical dotted line on the right marks the firms capacity. Current output
is half of that. Draw the line through A and parallel to TC. From 75% capacity output
point, draw the vertical line. B is the intersection. Draw the line TR2 through B. The
slope of TR2 gives the required output price.

BREAKEVEN ANALYSIS BETWEEN TWO ALTERNATIVES OR PROJECT

Break-even analysis can also be used to select among alternatives (e.g., projects or
construction processes). In order to perform break-even analysis between alternatives,
there needs to be a parameter (e.g., cost or revenue variables) that is common in both
alternatives. When two alternatives are compared, the break-even point represents the
point of indifference between the alternatives (i.e., the point at which two alternatives
are equally desirable) (Badiru 1996).
The steps to find the point of indifference between alternatives:
Find the common variable between the alternatives

Express the total cost of each alternative as a function of the common variable

Equate expressions and solve for the point of indifference

Select the alternative with higher variable cost (larger slope) if the expected level
is below the point of indifference, and select the alternative with lower variable
cost if the level is above the point of indifference.

For the example provided below, profit functions are graphed. This graph shows that
Project B is favorable over the other alternatives if the production is between 0 and
100 units, Project A is favorable if the production is between 100 and 200 units, and
Project C is favorable if the production is larger than 200 units.
Profit ($)

Project C
Project A

Project B
Units (X)
-200
-300

100

150

200

Selection of alternative is based on anticipated value of common variable:

Value BELOW breakeven; select the alternate with higher variable cost (Alt 1)
Value ABOVE breakeven; select the alternate with lower variable cost (Alt 2)

Example 5: There exist two alternative locations for an asphalt mixing plant to
transport materials from. Characteristics of these two locations and associated costs
are tabulated below. Which location is best for the asphalt mixing plant, the cheaper
Location A or closer Location B? (This example has been adopted from MIT Engineering Economics lecture
notes, copyright MIT, Environment & Civil Engineering Department).

Transportation distance
Transportation expense
Monthly rental expense
Set-up cost
Workmanship costs
Total volume available
Time to use the location

Location A
km
1.15/ m3-km
1000/month
15 000

6
$
$
$
0
50000 m3
4 months (85 days)

Location B
4.3 km
$ 1.15/m3-km
$ 5000/month
$ 25 000
$ 96/day
50000 m3
4 months (85 days)

Solution:
First obtain the total cost functions for all alternatives
Location A
Rental expense
Set-up cost
Workmanship costs
Transportation
Total Cost

Fixed Costs
4 month x $1000/month = $ 4000

Location B
4 month x $5000/month = $ 20 000

$ 15 000
$ 25 000
0
85 days x $96/day = $ 8160
Transportation/Variable costs
6 km x $1.15 x Q
4.3 km x $1.15 x Q
$ 19 000 + 6.9 Q
$ 53 160 + 4.945 Q

Equate the total cost functions to solve for volume to be transported for break-even
point
$ 19 000 + 6.9 QBE = $ 53 160 + 4.945 QBE
QBE = 17473 m3.
At 17473 m 3 of material usage, both sites are equally desirable. If less material is
transported than 17473 m3, then selecting location A is favorable, and if more volume is
expected to be transported than 17473 m3, then selecting location B is more favorable
with less variable cost.

Example: Perform a make/buy analysis where the common variable is Q, the number
of units produced each year. AW relations are:
(Note: In examples like the one given below, determine one of the parameters P, A, F, i, or n, with others
constant, that makes two elements equal)
AWmake. = -18,000(A/P, 15%,6) +2,000(A/F, 15%,6) 0.4Q
= -18,000 x 0.2642 + 2,000 x 0.1142 0.4Q
AWbuy = -1.5Q

AWbuy

10

AWmake

Solution: Equate AW relations, solve for Q

1.5Q = -4528 - 0.4Q ,
Q = 4116 per year

2
0

If anticipated production > 4116, select AWmake alternative (lower variable cost)
THE EXCEL SHEET HAS AN IN BUILT FUNCTION NAMED GOAL SEEK WHICH CAN BE
USED FOR BREAK EVEN ANALYSIS: Data
What-If Analysis
Goal Seek
If you want to learn it then arrange extra class other than regular classes, I will explain how to use it.
INTRODUCTION TO COMPOUND INTEREST FACTOR
Notations Used in Compound Interest
i = Interest rate per interest period*.
n = Number of interest periods.
P = A present sum of money.
F = A future sum of money.
A = An end-of-period cash receipt or disbursement in a uniform series continuing for n periods.
G = Uniform period-by-period increase or decrease in cash receipts or disbursements.
g = Uniform rate of cash flow increase or decrease from period to period; the geometric gradient.
r = Nominal interest rate per interest period*.
m = Number of compounding sub periods per periods*.
Concept of Compound Interest
Interest (i) applies to total amount (P + sum of all I) during each period.
Consider the following Cash flow:
A $1000 deposit for 5 years at 10% / year would result in:
Amount accrued
Year Begin Year Int. End year
1
P = 1000
100 F1 = 1100
F1 = P + Pi
2
1100
110 F2 = 1210
F2 = P + Pi+ (P + Pi) i
3
1210
121 F3 = 1331
F3 = P + Pi+ (P + Pi) i + (P + Pi+ (P + Pi) i) i
4
1331
133
1464
= P + Pi+ Pi+Pi2 + Pi+Pi2 + Pi2 + Pi3
5
1464
146
1610
= P + 3Pi + 3Pi 2 + Pi3
= P(1+3i +3i2 + i3) = P(1 + i)3
Hence F = P(1 + i)N where (1 + i)N is called Compound Amount Factor.

Solving Problems
It is now easy to solve problems regarding the Equivalence of Present (P) and Future (F) values over
time (N) with interest (i). These steps will help: 1) Identify cash flows. 2) Identify P, F, i & N.
3) Determine the missing value. 4) Solve for missing value using equation.
Example: What annual interest rate must you get if you need $7000 in 4 years and have $5000
to invest now?
P = $5000,

F = $7000,

N = 4 years,

i =?

7000 = 5000(1 + i)4

7000 / 5000 = (1 + i)4
(1.4)1/4 = 1 + i
1.0878 = 1 + i
0.0878 = i = 8.78% / year
Functional Notation
Standardized notation has been established to avoid writing the equation each time, and to give a
logical method by which to find the correct factor to use.

Read the factor as saying "Find F given P at i% for N periods".

Example: What is F for $1000 deposit for 5 years @ 10% / year?
F = 1000( F/P,10,5)
(F/P,10,5) = 1.611 --- See table at the end of any book on Engineering Economy
F = 1000(1.611) = $1611
Example : Find i for P = $5000, F = $7000, N = 4 years
Using F = P(F/P, i, N)
7000 = 5000(F/P, i, 4)
1.4 = (F/P, i, 4)
Search the Compound Interest Factor tables (Pages 180 - 208) to find the Interest rate that matches
the factor.
i = 9%
(F/P, 9, 4) = 1.412, i = 8%
(F/P, 8, 4) =1.360
Since an even i value can't be found to match (F/P,i,4) = 1.4, you must interpolate to find the
solution.

Interest Factor Formulas

Compound Amount:
To find F, given P (F/P, i, n)
Present Worth:
To find P, given F (P/F, i, n)
Series Compound Amount:
To find F, given A (F/A, i, n)
Sinking Fund:
To find A, given F (A/F, i, n)
Capital Recovery:
To find A, given P (A/P, i, n)
Series Present Worth:
To find P, given A (P/A, i, n)
Arithmetic Gradient Uniform Series:
To find A, given G (A/G, i, n)
Arithmetic Gradient Present Worth:
To find P, given G (P/G, i, n)
Geometric Gradient:
To find P, given A1, g (P/G, g, i, n)