Break Even and Payback

Analysis
Class 13
 Breakeven Analysis
• “How many people should travel on my road for
me to get my money back”?
• A Risk Assessment and not an Alternative
Evaluation technique
– Used to Estimate Profit and Loss
• Definition : the number of “units produced” such
that costs are equal to revenues
• Cost has two components – fixed and variable
• Equate EUAW of costs and revenues to find the
break-even point
 Fixed and Variable Costs

Total Cost
Cost Rs/yr

Variable Cost

Fixed Cost

Units Per Year, Q

 Revenues
Revenues Rs/yr

Units Per Year, Q

 Graphical Break-Even
Revenue
Total Cost

Variable Cost
Cost Rs/yr

Fixed Cost

QBE
Units Per Year, Q
 Points to Note
• You can bring down the Break-Even by
reducing Fixed or Variable Costs
• If the Revenue-Quantity Relationship or
the VC-Quantity Relationship is not linear,
you may have multiple Break Even points
– You may then also be able to fine a
‘Maximum Profitability Point’
 What can I do with this?
• Determine when I will break-even

• Based on my production (or no. of road

users) decide on my costs and technology
 Example
• A plant has historically produced at around 80%
of capacity in its production of 14,000 units per
month. However, current production is 8000
units per month. Fixed Costs are Rs. 75,000 per
month. Variable Costs are Rs. 2.50 per unit and
each unit will fetch Rs. 8.00 in the market.
• 1. What are the profits if 14000 units are
produced?
• 2. Will the plant Breakeven at 8000 units?
• 3. If not, what should the variable cost be for
breakeven at 8000.
 Solution
• Monthly Cost =
– Fixed Cost + Variable Cost x Quantity
• Monthly Revenue =
– Cost per Unit x Quantity
• For Break-Even
– FC + VCxQ = RxQ
– 75,000 + 2.5Q = 8Q
– QBE = 13,636 Units Per Month
 Answers
• 1. 13,636 Units Break Even
– Profits are derived from the remainder
– Profit = 14,000x(8-2.5) – 75,000 = Rs. 2000
• 2. 8000 units will represent a loss
– Value of loss = 8000x(8-2.5) – 75,000 = -31K
• To Calculate VC at breakeven of 8000,
– 75,000 + 8000xVC = 8x8000
– VC < 0
– Cannot break even at 8000 even if VC is 0!
 Comparing Between
Alternatives
• Very often it is useful to find the number of units at which
the cost is common to two proposals.
Total Cost: Option 2

Total Cost: Option 1

Break Even
Total Cost

Units>QBE -> Option 1

Units<QBE -> Option 2

QBE

Total Units
 Example: i=10%

Machine A Machine B
Initial Cost (Rs.) 23000 8000
AOC (Rs.) 3500 1500
Salvage Value (Rs.) 4000 0
Life (Yrs.) 10 5
Operator Charges 12 24
(Rs./hr)
Output (tons per hour) 8 6

1. How many tons of output should be generated per year to

justify the purchase of Machine A?
2. If you anticipate a demand of 2000 tons a year, which
machine should you choose?
 Solution 1
• If the breakeven amount of tons produced
per year is ‘x’:
• Annual Variable Cost for Machine A
– = 12x/8
• EUAWA = 23000(A/P,10%,10) –
4000(A/F,10%,10) + 3500 + 12x/8
• EUAWA = 6992 + 1.5x
 Solution 1
• If the breakeven amount of tons produced
per year is ‘x’:
• Annual Variable Cost for Machine B
– = 24x/6 = 4x
• EUAWB = 8000(A/P,10%,5) + 1500 + 4x
• EUAWB = 3610 + 4x
 Solution 1
• To find the breakeven cost, equate the
EUAW for A and B
• 6992 + 1.5x = 3610 + 4x
• X = 1353 tons per year
• At least 1353 tons are to be produced to
justify the purchase of Machine A
 Solution 2
• If we set x at 2000, then
• EUAWA = 6992 + 1.5x
– EUAWA = Rs. 9992
• EUAWB = 3610 + 4x
– EUAWB = Rs. 11,610
• Purchase Machine A
– Intuitive from Solution 1, as x>1353
 Class Exercise
• You can either make toys or purchase them. Purchase cost is Rs.
0.50 per toy. To manufacture, you need two machines A and B with
details below. You will need 4 laborers for 2 machines at the cost of
Rs. 2.50 per hour. In a normal 8 hr day period, machines can
produce parts sufficient to manufacture 1000 toys. MARR = 15%.
How many toys should you manufacture to justify purchasing the
machines?

Machine A Machine B
First Cost (Rs.) 18000 12000
AOC (Rs.) 6000 5000
Salvage (Rs.) 2000 -500
Life (Years) 6 4
3 Yr Overhaul 3000
(Rs.)
 Solution
• Cost of Manufacturing ‘x’:
– VC = 4*2.50*8x/1000 = 0.08x
– FC = EUAWA + EUAWB
• =[18,000(A/P,15%,6) – 2000(A/F,15%,6) + 6000 +
3000(A/F,15%,3)] + [12,000(A/P,15%,4) +
500(A/F,15%,4) + 5000
• Cost of purchasing x = 0.5x
• Breakeven: 0.5x = FC + VC
– Solving for x, x = 48,458 units per year
 Payback Period Analysis
• The payback period is the number of years
that an asset must be retained and used to
recover the initial investment with a stated
return
• It is a supplemental method to PW, EUAW
etc – not an alternative
• Method: Set Net PW to 0 and solve for ‘n’.
– A life greater than ‘n’ will yield a payback.
Values lower than ‘n’ will not
 Example
• A machine purchased for Rs. 18,000 is
expected to generate annual revenues of
Rs. 3,000 and have a salvage value of Rs.
3000 at any time during the 10 years of
anticipated ownership. If a 15% per year
return is required, then compute the
payback period
 Solution
• Assume Payback Period = ‘n’
• Net Cash Flow on a Present Worth Basis
– = -18,000 + 3000(A/P,15%,n) +
3000(P/F,15%,n)
• Set this to 0 and solve for ‘n’.
• n = 15.3 years.
– n>10. You will never get a payback within the
life of this asset.
 Life Cycle Costing
• LCC is the total cost of the item over its
lifecycle
• Includes
– R&D costs
– Production Costs
– Operations and Support Costs
 Class Exercise
• Determine the payback period for an asset
tht initially costs Rs. 8000, has a salvage
of Rs. 500 when sold and has a net profit
of Rs. 900 per year. The required return is
8% per year. If the asset will be used for 5
years by the owner, should it be
purchased?
Thank You