BREAK EVEN ANALYSIS &THEORY OF MAKE AND BUY DECISION

G P Kurien

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BREAK EVEN ANALYSIS

A standard approach to choosing among alternative processes or equipment

Model seeks to determine the point in units produced (and sold) where we will start making profit on the process or equipment

Model seeks to determine the point in units produced (and sold) where total revenue and total cost are equal

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Assumptions

Total Cost of production can be divided into fixed cost and variable cost.

Fixed cost remains constant.

Variable cost varies proportionally with volume of production.

Selling price does not change with volume of sales.

Productivity is constant.

Every product produced is sold.

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Break-Even Analysis (Continued)

Contribution, C = Unit price to customer (p) - Variable costs per unit (v)

BEP = F/C

Break-even Demand=

Purchase cost of process or equipment

Price per unit - Cost per unit

or

Total fixed costs of process or equipment (F)

Unit price to customer - Variable costs per unit

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Example

Suppose you want to purchase a new computer that will cost Rs 5,000. It will be used to process written orders from customers who will pay Rs 25 each for the service. The cost of labor, electricity and the form used to place the order is Rs 5 per customer. How many customers will we need to serve to permit the total revenue to break-even with our costs?

Break-even Demand:= Total fixed costs of process or equip.

Unit price to customer – Variable costs=5,000/(25-5)=250 customers

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GRAPHICAL SOLUTION

0

2000

4000

6000

8000

10000

12000

100 200 300 400

Fixed

Revenue

Total Cost

quantity

cost

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Example 2A manufacturer has identified following options for making a machined part. It can buy the part at Rs. 200 per unit. It can make the part on a semi automatic machine at Rs75 per unit. It can also make the part in a machine centre at Rs 15 per piece. There is negligible fixed cost if the item is purchased; a semi automatic lathe costs Rs 80,000; and a machining centre costs Rs. 200,000.

What should be the best manufacturing option if the demand for the product is 1) 500 Units; 2) 750 Units; 3) 1000 Units & 4)2500 Units

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MARGIN OF SAFETY

Distance between breakeven point and output produced.

Margin of Safety = (Sales – Sales at BEP) /Sales

A large margin of safety indicate profit even if there is reduction in sales.

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Angle of Incidence

Angle between sales income and total cost line.

Large angle of incidence indicate large profit and favorable business position.

Narrow angle of incidence indicates large part of variable cost in total cost.