Chapter 8 - Unit 1: IET 350 Engineering Economics

Chapter8 Unit1
BreakevenAnalysis
IET350
EngineeringEconomics
LearningObjectives Chapter8
Uponcompletionofthischapteryoushouldunderstand:
Calculatinglinearbreakevenpoints.
Calculatingnonlinearbreakevenpoints.
Effectofchangesincostsandrevenue.
Strategiesassociatedwithcapacitylimits,expansionand
profits.
Isocostsandbreakevenbetweenproducts.
Legislationandpublicpolicyasitrelatedtobreakeven.
2
LearningObjectives Unit1
Uponcompletionofthisunityoushouldunderstand:
profits.
3
Introduction
Breakevenanalysisisatoolthatcanbeusedto:
Determinethevolumeofaproductorservicethatmust
beproducedtocoverallcostsandgenerateaprofit.
Choose between two or more alternatives

Choosebetweentwoormorealternatives.
Determinemakevs.buydecisions.
Assistinmanagingassetintensiveandlaborintensive
organizations.
Breakevenanalysisisalsoknowascostvolumeprofit
analysis.
4
LinearBreakeven
Linearbreakevencanbeillustratedonthebreakevengraph.
Quantityisplottedontheindependent(horizontal)axis.
Cashflow($)isplottedonthedependent(vertical)axis.
LinearBreakeven
Linearbreakevenassumesthattotalrevenue,variablecostand
fixedcostcanbeapproximatedbystraightlines.
Total revenue constant $/unit
Totalrevenue=constant$/unit.
Fixedcost=singlecostamount.
Variablecost=constant$/unit.
Totalcost=fixed+variablecost
FixedCosts
Fixedcosts(FC)donot changewithchangeinoutput.We
assumethatevenifquantity=0,fixedcostswilloccur.
Sincefixedcostsareindependentofquantity,theyare
p
plottedasahorizontalline.
Examplesoffixedcosts:
Rent
Managementsalaries
Depreciation
Propertytaxes
Buildingmaintenance
Advertising
Engineeringsalaries
VariableCosts
Variablecosts(VC)changeproportionallywithchangein
output.
Variablecostsareplottedasalinebeginningattheorigin
withslope=$VC/unit.
p $ /
Examplesofvariablecosts:
Directmaterial
Directlabor
Productionutilities
Shippingcost
Equipmentmaintenance
8
TotalCosts
Totalcosts(TC)=Fixedcosts(FC)+Variablecosts(VC)
Forlinearcosts,thetotalcostlineisparalleltothevariable
costlinewithanoriginequaltothefixedcost.
TotalRevenue
Totalrevenue(TR)isthesellingpriceoftheproductor
servicetimesthequantity.
Totalrevenueisplottedasalinebeginningattheoriginwith
p $p /
slope=$price/unit.
10
TotalRevenueandDemand
Demandcurvesillustratetherelationshipbetweenproduct
orservicesellingprice($/unit)andthedemand(units/year).
Totalrevenue(TR)istheareaunderthedemandcurvefora
g
givenquantityandresultingprice.
q
y
gp
11
BreakevenQuantity
Breakevenquantity(QBE)occursattheintersectionofthe
totalrevenue(TR)andtotalcost(TC)lines.
Breakevenoccurswhentotalcost=totalrevenue.
12
BreakevenQuantity
Outputquantity<breakevenquantity(QBE)resultsinaloss.
Outputquantity>breakevenquantity(QBE)resultsinaprofit.
ProfitArea
TR>TC
Profitismaximized
inthissituationby
increasingoutput
tothelimitof
capacity.
LossArea
TC>TR
13
BreakevenQuantity
Breakevenquantity(QBE)canbedeterminedmathematically
bysettingtotalrevenue(TR)equaltototalcost(TC)and
solvingforthequantity:
TR = TC
TR=FC+VC
Q BE price unit =FC+Q BE cost unit
Q BE =
FC
price
cost
unit
unit
14
UnitCostsandRevenues
Unitcostsandunitrevenuesareusefulmeasuresformany
benchmarkingandanalysisneeds.
Variablecostsisalreadyaunitvalue($VC/unit).
Revenue is already a unit value ($selling price/unit)

Revenueisalreadyaunitvalue($sellingprice/unit).
Fixedcostscanbeconvertedintoaunitvaluebydividingthe
fixedcostbyvariousquantities.
Totalcost/unitcanbedeterminedbyaddingfixedcost/unit
andthevariablecost.
TC
FC
unit = unit+VC
15
Unitcostsandcanbeplottedagainstquantity:
Variablecostandsellingpricearenowhorizontallines.
Fixedcost/unitandtotalcost/unitnowbecomecurves.
16
Theunitcostgraphshowstheimportantconcept Asthe
quantityofoutputincreases,thetotalcostperunitdecreases.
17
ExampleProblem8.1
ExampleProblem8.1Solution
18
EndUnit1Material
GotoUnit2NonlinearBreakeven
19
Chapter8 Unit2
NonlinearBreakeven
IET350
profits.
21
NonLinearBreakeven
Linearbreakevenassumesrevenueandcostscanbe
approximatedbystraightlines.Thisassumptionssimplifiesthe
analysisbutdoesnotmatchrealworldsituations.
Productionsituationshaveamaximumcapacitythatcannotbe
exceededintheshortterm.
Fixedcostschangeatsomepointduetotheneedforadditional
resources.Example hiringanadditionalsupervisor.
Variablecostsmaynotbeproportionaloverallquantities.
Example volumediscountsfordirectmaterials.
Totalrevenuemaynotbeproportionaloverallquantities.
Example volumediscountsforincreasedorderquantities.
22
NonLinearBreakeven
Nonlinearbreakevenisillustratedintextfigure86.Notethat:
Maximumcapacityisrepresentedbytheverticaldashedline.
Fixedcostsandvariable
costs approach vertical
costsapproachvertical
lineasoutputquantity
approachesmaximum
capacity.
Morethanonebreakeven
quantity(QBE)mayoccur
ascostsandrevenue
change.
23
NonLinearBreakeven
Generally,inlinearbreakevenanalysisprofitismaximizedby
increasingoutputtothelimitofcapacity.
Withnonlinearcostsand
,
p
revenues,maximumprofit
mayoccuratsomequantity
anddecreasewithgreater
outputasillustratedin
figure86.
Highernonlinearcostscan
resultinalossathigher
outputquantities.
24
NonLinearBreakeven
Anothercategoryofcostsarepartiallyfixedandpartially
variable.Thesearealsoknownassemifixedandsemivariable.
Partiallyfixedcostsmaybelinearoveranoutputrange,then
y
p
incrementallyincreasetoanotherlinearlevel.Example
anothersupervisor(fixedcost)ishiredduetotheincreasein
productionvolume.
Partiallyvariablecostsmaybelinearoveranoutputrange,
thenthecost/unitmaychangeresultingisachangeinslopeof
theline.Example directmaterialcostperunitdecreasesdue
tovolumepurchasediscounts.
25
NonLinearBreakeven
Partiallyfixedcostisillustratedonthefollowinggraph.
Notethatthehorizontallineincrementallyshiftswhen
additionalfixedcostisadded.
While profit occurs at

Whileprofitoccursat
quantitiesgreaterthan
breakeven,thelevelof
profitchangeswhen
thefixedcostchanges.
Iftheincremental
changeinfixedcosthad
beengreater,theprofit
26
mayhaveturnedtoloss.
ExampleProblem8.2
27
EndUnit2Material
GotoUnit3AnalysisofBreakeven
28
Chapter8 Unit3
AnalysisofBreakeven
IET350
profits.
30
10
HowChangesEffectQBE
Wecanisolateandchangeonecomponentinbreakeven
analysisanddeterminehowitwilleffectthebreakevenpoint.
Example:
Fixedcost(FC)canbechangedwhileholdingtotalrevenue
( )
g
g
(TR)andvariablecost(VC)constant.
Totalcost(TC)willchangesinceTC=FC+VC.
Sincetotalcostchanges,theintersectionbetweentotal
costandtotalrevenuewillchangeresultinginachangein
thebreakevenpoint(QBE).
Overthenextfewslideswewilllookateachcomponent.
31
HowChangesEffectQBE
Increasingfixedcosts(FC)willcausethebreakeventoincrease
sincethetotalcost(TC)lineisshiftedupward.
Figure87ChangesinCostsandSellingPriceAffecttheBreakevenPoint
(Bowmantextpage308)
32
HowChangesEffectQBE
Decreasingfixedcosts(FC)willcausethebreakeventodecrease
sincethetotalcost(TC)lineisshifteddownward.
(Bowmantextpage308)
33
11
HowChangesEffectQBE
Increasingvariablecosts(VC)willcausethebreakeventoincrease
sincethetotalcost(TC)linesslopeincreases.
(Bowmantextpage308)
34
HowChangesEffectQBE
Decreasingvariablecosts(VC)willcausethebreakevento
decreasesincethetotalcost(TC)linesslopedecreases.
(Bowmantextpage308)
35
HowChangesEffectQBE
Increasingthesellingpricewillcausethebreakeventodecrease
sincethetotalrevenue(TR)linesslopeincreases.
(Bowmantextpage308)
36
12
HowChangesEffectQBE
Decreasingthesellingpricewillcausethebreakeventoincrease
sincethetotalrevenue(TR)linesslopedecreases.
(Bowmantextpage308)
37
AreaGraphs
Areagraphsdisplaybreakeveninformationinadifferentformat
toprovideanotherviewofbreakeven,profitandcapacity.
Anareagraphisplottedforaspecificoutputlevelandshows:
Variable cost
Variablecost
Fixedcost
Profit
Maximumcapacity
Unusedcapacity
38
AreaGraphs
Potentialcapacityisillustratedbytheunusedcapacityfalling
betweencurrentoutputandmaximumcapacity.
Ifoutputisincreasedtoutilizeunusedcapacity,onlyvariable
costswillincrease.
Additionaloutpututilizing
theunusedcapacityresults
inahigherprofit/unitsince
thefixedcostsdonot
increase.
Therefore,afirmcansell
productatadiscountsince
39
onlyvariablecostsmustbecovered.
13
PrivateLabelStrategy
SearssellsavastvarietyofproductsundertheSears,DieHard,
Kenmoreand Craftsman brandnames.Manyoftheseproducts
areproducedbymanufacturerswhoalsoretailthesameor
similarproductstoconsumers.Examples:
Craftsman toolshavebeenmadebyStanley inthepast

whoalsomarketstoolsundertheStanley name.
Kenmore appliancesaremanufacturedbyWhirlpoolCorp.
ManufacturersoftheproductsselltoSearsatalowerprice
thantheymarkettheproductundertheirowntrademark.
Thisapproachisprofitabletothemanufactureriftheyutilize
40
theirunusedcapacitytoproducetheproduct.
StrategyLimitations
Generally,increasingoutputthroughstrategiessuchasprivate
labelmarketingyieldincreasedprofits.
However,therearelimitations:
Marketlimitations
Market
limitations iftheadditionaloutputcannotbesold
if the additional output cannot be sold
thecurrentoutputismoreefficient.
Profitlimitations ifincreasingoutputcausesthefixed
cost,variablecostrate,and/orrevenueratetochange,the
currentoutputmaybeabetteralternative.
Capacitylimitations physicalcapacityofthefacilitiesand
organizationmaylimitexpansionintheshortterm.
41
CapacityLimitations
Capacityisbasednotonlyonphysicalfacilities,butalsoonthe
organizationalcapacity.Capacityinclude:
Buildingresources spaceforproductionandwarehousing
p
rawmaterialsandfinishedproduct.
Equipmentresources availabletimeonallproduction
relatedequipmentrequiredtoproducetheproduct.
Humanresources staffingofproduction,management,
sales,engineering,supportandtechnicalareas.
Financialresourcesthefirmmustprovideadditionalcash
outlayswhenincreasingoutput.
42
14
BalancingCapacity
Capacitylimitationsmayresultfromthemanufacturingprocess.
Producttypicallymovesthroughmultipleproductionareas
(departments)whichmaynothaveequalcapacityorefficiency.
Productmaybeheldasin
Product
may be held as inprocess
processinventorybeforeprocesses
inventory before processes
thatlimitcapacity.Inprocessinventoryhasaholdingcost
associatedwithitthatwillaffectoverallproductcost.
43
BalancingCapacity
Balancingcapacityinvolvesremovingthebottleneckresulting
inincreasedcapacity.Strategiescaninclude:
Operatethecapacitylimitingprocess/equipmentmore
hoursbyworkingadditionalshiftsorovertime.
Purchaseadditionalcapacity/equipmentforthelimiting
processtomatchthecapacityoftheremainingprocesses.
Increasetheefficiencyandproductivityofthelimiting
process/equipmentthroughprocesschangesor
replacementwithmoreefficientequipment.
Limittheproductionrateoftheremainingprocessesto
matchthelimitingprocess.
44
BreakevenandTVM
Breakevenandtimevalueofmoneyarenotmutuallyexclusive
analysistechniques.
Breakevenshouldincorporatetimevalueofmoneymethods
whenevercostsandrevenuesdonotoccurinthesametime
period.Example:
Acquisitionofequipmentoccursatonepointintime,but
thefixedcostassociatedwithpurchasingtheequipment
wouldbeincludedasanannualcostinbreakeven.
Anticipatedfuturecostforperiodicequipment
rehabilitationareanoperatingexpensewouldbeincluded
asanannualfixedcostinbreakeven.
45
15
EndUnit3Material
GotoUnit4Isocosts
46
Chapter8 Unit4
Isocosts
IET350
profits.
48
16
BreakevenBetweenProcesses
Breakevensofarhasbeenbasedonsettingrevenue=cost.
Breakevencanalsobeusedtoanalysiswhentwocostsare
equaltoeachothersuchasthecostassociatedwithtwo
productionprocesses:Cost
p
p
A =CostB.
Isocost pointistheequalcostpointorthepointatwhichtwo
costareequal.
Isocostanalysisiscommonlyusedto:
Selectbetweenalternativemanufacturingmethods.
Determinewhetherproductshouldbemadeorpurchased.
49
IsocostPoint
Graphically,thevariableandfixedcostsforeachalternativeare
usedtodeterminethetotalcostcurves.
Isocostpointoccurswherethetwototalcostcurvesintersect.
Isocostpointsarealsoknownasindifferencepoints.
p
p
50
IsocostPoint
Quantitiesotherthantheisocostpointquantityindicatethe
bestalternativebasedonlowesttotalcost.Forfigure817:
Outputquantity<1,400units/year selectalternativeB.
Outputquantity>1,400units/year
p q
y ,
/y
selectalternativeA.
SelectB
TCA >TCB
SelectA
TCA <TCB
51
17
IsocostQuantity
Isocostquantity(QIC)canbedeterminedmathematicallyby
settingtotalcostforalternativeA(TCA)equaltototalcostfor
alternativeB(TCB)andsolvingforthequantity:
TC A = TCB
FC A +VC A =FCB +VCB
FC A +Q IC (cost unit )A =FCB +Q IC (cost unit )B
Q IC =
FC A FCB
(cost unit )B (cost unit )A

52
ExampleProblem8.3
53
Make/BuyAnalysis
Decisionswhethertopurchaseaproductorservicefroman
outsidevendororwhethertoproducetheproductorservice
inhouseisknownasmakeorbuy.
Makeorbuyanalysisisaspecialcaseofisocostanalysis.
y
y
p
y
Makeoptionincludesfixedandvariablecostsasbefore.
Buyoptionincludesonlyvariablecostwhichisthepurchase
priceoftheproductorservice.
Therefore,theisocostisdeterminedby:
VCmake +FCmake =VCbuy
54
18
IsocostPoint
Quantitiesotherthantheisocostpointquantityindicatethe
bestalternativebasedonlowesttotalcost.Forfigure820
Outputquantity<QIC units/year selectbuyoption.
Outputquantity>Q
p q
y QIC units/year
/y
selectmakeoption.
p
SelectMake
TCmake <TCbuy
SelectBuy
TCmake >TCbuy
55
IsocostPoints
Morethantwoalternativesresultinmultipleisocostpoints.
Eachalternativegeneratesanisocostpointwitheachother
alternative.However,notallisocostpointsaremeaningful.
Isocostbetween
Isocost
between
AutoandBuy
doesnotenter
intothedecision.
SelectAuto
TCauto <TCexist
TCauto <TCbuy
SelectBuy
TCbuy <TCexist
SelectExit
TCbuy <TCauto
TCexist <TCbuy
TCexist <TCauto
56
ExampleProblem8.4
57
19
PublicPolicy
HistoryshowsthatpubicpolicyintheUnitedStatesaddresses
monopoliesandcompetition.
Throughlegislation,monopoliesareillegalexceptwherefederal,
stateandlocalgovernmentsgrantexclusiverights.
Monopoliesoccurwhenthereisasingleproviderorwhen
pp
p
/p
onedominatesuppliersetsthepricefortheservice/product.
Examples utilities(power,water,gas),firstclassmail
service,telecommunications(cable,landtelephone),etc.
Traditionally,monopolieswereallowedtoexistinassetintensive
organizationswithprofitsregulatedbygovernmentagencies.
58
PublicPolicy
Assetintensivefirmssuchasutilitieshavehighfixedcostsanda
relativelylowvariablecostrate.Therefore,changesinquantity
resultinlargeincreasesinrevenue.
Laborintensivefirmshavelowfixedcostsandarelativelyhigh
y g
variablecostrate(directlabor).Therefore,changesinquantity
resultinsmallincreasesinrevenue.
59
PublicPolicy
Assetintensivefirmswereandareallowedtooperateas
monopolieswithgovernmentregulationtoinsuretheserviceor
productisprovidedasnecessary.
Example
p
providingelectricitytoremotelocationswhere
p
g
y
thefixedcostofinstallingthepowerlineswouldnotbe
recoveredthroughrevenue.
Deregulationhasandischangingthejustificationfor
monopolies.Thetextgivestheexampleoftheairlineindustry
whichwasderegulatedinthe197080s.
Telecommunicationsisthelatestindustrytobesubjectto
deregulationdiscussionsandactions.
60
20
EndChapter8Material
StudentStudyGuide Chapter8
HomeworkAssignment ProblemSet8
61
21

Chapter 8 - Unit 1: IET 350 Engineering Economics

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Chapter8 Unit1

Choose between two or more alternatives

Q BE price unit =FC+Q BE cost unit

Revenue is already a unit value ($selling price/unit)

While profit occurs at

Craftsman toolshavebeenmadebyStanley inthepast

(cost unit )B (cost unit )A

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