Chapter 8 Breakeven, Sensitivity, and Payback Analysis

Hello Class. Welcome to the final chapter of this course. I hope that you enjoyed the
course and have learned some new things that can apply to your future work and to
your personal finances. In any good economic study we start with the definitions so that
we are all on the same page.

We start with breakeven analysis. Breakeven analysis can be performed for one project
analysis or for two alternatives. For a single project, it determines a parameter value
that makes revenue equal to cost .For two alternatives the breakeven is when they are
equally acceptable bases on a calculated of one parameter common to both
alternatives. Make or buy decisions for contractor services, manufactured components,
or international contracts are routinely based upon a breakeven analysis.

Sensitivity analysis is a technique that determines the impact on a measure of worth.

(PW, AW, ROR or B/C. It answers the question What If?.

Payback period is a good technique to initially determine. The technique is initially used
to determine if a procject is financially acceptable. It determines if the amount of time
necessary on a project to do two things, develop enough cash flow to recover the initial
investment and to meet or eceed the MARR.

Figure 8.1, page 208 of your text, shows some comparisons When we do breakeven
analysis we will often have to develop a graphical representation of the data.

Fixed Costs (FC) includes costs such a buildings, insurance, fixed overhead, and
information systems. These costs do not vary with the production rates and are usually
linear. Fixed costs are those that you would have if no product was produced.

Variable Costs (VC) are cost that increase or decrease with amount of production. They
include direct labor, subcontractor materials, advertising, and marketing to name a few.
These costs are usually directly related to the manufacturing of a product. The more
product, the more hours that are required to produce them. Variable costs can be
shown mathematically by the equation vQ, where v stands for the variabke cost per unit
and Q is the number of units produced.

FC + VC = TC (total cost)

Profit = revenue minus total cost = R TC

When R an TC are linear functions and R = TC.This is the breakeven point, Figure 8.2
R = TC we can substitute for R rQ and we can substitute for TC, VC + FC

So rQ = FC + VC + vQ Where r= revenue per unit and v= variable cost per unit

Q BE = FCrv Breakeven equals FC divided by revenue cost per unit minus variable cost
per unit

Figure 8.2 shows the relation < when we have linear function of Total cost to Revenue.

The intersection is breakeven. We see in 8b that as we reduce TC we get lower

breakevens.

Figure 8.3 shows how nonlinear functions of TC and R related. Notice we now two
breakeven points, but only one point where we maximize profit.

Problem 8.1

To solve this problem we first calculate the breakeven point at 7500 gallons.
FC 900
Thus Q = rv = .3 .18 = 7500 gallons

However when we do the second part of the equation the first answer plays no part as
we now have two different breaks in the price per gallon

So revenues now require you to add the revenue at 5000 gallon at .30 per gallon to
some unknown quantity Q at .2 a gallon and costs the fixed cost of $900 plus .18 times
the first 5000 gallons plus Q at .18 per gallon

This is now Revenues = Cost .3(5000) + .2(Q) = $900 + .18(5000 + Q) = 15000

gallons This means that we need to add 15,000 gallons, this is the amount above the
5000 gallons where we reach break even. On the graph this is $4500

Another equation that you can use for breakeven analysis is a revenue cost equation

R/Q = r and the TC is divided by Q

TC FC+vQ FC
Therefore C = Q = Q = Q +v

There is a good example of the use of PW, FW and AW for use in breakeven analysis
on page 213 of your book. Please read it.

Breakeven Analysis Between two Alternatives

Breakeven used to determine the value of aq parameter that is common to two
alternatives. Breakeven analysis usually involved revenue or cost variables common to
both alternatives. It is common to find the breakeven value by equating PW or AW
equivalence relations. The AW is preferred when the variable units are expressed on a
yearly basis or when alternatives have unequal lives.

The following step determine the breakeven point of a common variable,

1. Define the common variable and its dimensional units

2. Use the AW or PW analysis to express the total cost of each alternative as a
function of the common variable
3. Equate the two relations and solve for breakeven value
4. The select guideline is based on the selected level of the common variable and
the size of the variable cost.

Expected variable level < breakeven value: Select variable with the higher
variable cost. (larger slope on the TC line

Expected level > breakeven value: Select alternative with lower variable cost
(smaller slope on the TC line.

Figure 8.5 on page 213 shows a very good example of this.

Problem 8.2

Set up table A (auto) M (manual)

Cost of machine $ 23,000 $8000

Life 10 yrs 5 years

Maint $3500/yr $1500/yr

Salvage $4000 0

Output 8 tons/hr 6tons/hr

Operator rate $24/ hr $36/hr ( 3men at $12/hr)

This helps to keep the figures in some kind of order

1. Find variable annual cost: let x = represent number of tons per year
 $2 4 1 hour x tons
a. Annual VC = hour 8 tons year = 3x
b. AW AW= -23000(A/P,10%,10) + 4000(A/F,10%,10) +-3500 -3x =
-6992 -3x

2. Find the annual cost for the manual machine

a. Annual VC = $12 hour
x 3oper x1hour x xtons
x 6tons x year = 6x
b. AW = -8000(A/P,10%,5) -1500-6x
-$3610 6x

Equate the two costs 6992 -3x = 6992 -3x x = 1127 tons

If the output is over 1127 ton select the auto. If less purchase the manual

Sensitivity Analysis for Variations in Estimates.

Usually one factor at a time is varied and independence with other factors is assumed.

This assumption is not completely correct in real world situations, but it is a practical
way to evaluate variations, Sensitivity analysis how a measure of worth ie, PW,AW,
ROR or B/C and the and the alternative may be altered if a particular parameter varies
over a stated range of values. For example some variation in MARR will not likely alter
the decision.

There are three types of sensitivity covered in this section.

1. Variation of one parameter at a time for a single project.

2. Variation of more than one factor for a single project,
3. Sensitivity of selection from multiple mutually exclusive alternatives to variation of
more than one parameter.

A general procedure to conduct a sensitivity analysis follows these steps.

1. Determine which parameter of interest might vary from the most likely estimated
value
2. Select the most probable range (numerical or percentage) and an increment of
variation for each parameter.
3. Select the measure of worth
4. Compute the results for each parameter using the measure of worth.
5. To better interpret the sensitivity graphically display the parameter versus the
measure of worth.

Problem 8.4 Is really self explanatory if you have trouble with this go to Ask the
Professor and let me know. Even the graphing and the explanation are easy

When sensitivity of several parameters is considered for one project using a single
measure of worth, it is helpful graph percentage change for for each parameter
using a single measure of worth. Problem 8.5 shows this technique.

Sensitivity Analysis of Multiple Parameters for Multiple Alternatives

The solution for these is really just more of the same. The easiest way is to set up
the table 8.1 There is really nothing new. Again if you have a problem just Ask the
Professor

I hope that you have enjoyed this course. I am sure that you will find what you
learned helpful in your career and in your personal life, I know that it did for me. I
know that at times there was some difficulty in understanding the problems, but I
think that you will find that it is worth it. As I said in the beginning this was a problem
solving course. You had many problems for the assignments, midterm, and final. I
am sure that if you are reading this you were successful in those attempts.

GOOD LUCK on the final.