Break-Even Analysis

Study of
interrelationships
among a firms sales,
costs, and operating
profit at various levels
of output
Break-even point is
the Q where TR = TC
(Q
1
to Q
2
on graph)
TR
TC
Q
$s
Profit
Q
1
Q
2
Linear Break-Even Analysis
Over small enough range of output levels TR and
TC may be linear, assuming
Constant selling price (MR)
Constant marginal cost (MC)
Firm produces only one product
No time lags between investment and resulting
revenue stream
Graphic Solution Method
Draw a line through
origin with a slope of P
(product price) to
represent TR function
Draw a line that
intersects vertical axis
at level of fixed cost
and has a slope of MC
Intersection of TC and
TR is break-even point
TR
TC
FC
Break-even
point
MC
P
1 unit Q
1 unit Q

Q
$s
Algebraic Solution
Equate total revenue and total cost functions and solve for Q
TR = P x Q
TC = FC + (VC x Q)
TR = TC
P x Q
B
= FC + VC x Q
B
(P x Q
B
) (VC x Q
B
) = FC
Q
B
(P VC) = FC
Q
B
= FC/(P VC), or in terms of total dollar sales,

PQ = (FxP)/(P-VC) = ((FxP)/P)/((P-VC)/P) = F/((P/P) (VC/P))
= F/(1-VC/P)
Related Concepts
Profit contribution = P VC
The amount per unit of sale contributed to
fixed costs and profit
Target volume = (FC + Profit)/(P VC)
Output at which a targeted total profit would
be achieved
Example 1 how many Christmas trees
need to be sold
Wholesale price per tree is $8.00
Fixed cost is $30,000
Variable cost per tree is $5.00
Solution
Q
(break-even)
= F/(P VC) = $30,000/($8 - $5)
= $30,000/$3 = 10,000 trees
Example 2 two production methods to
accomplish same task
Method I : TC
1
= FC
1
+ VC
1
x Q
Method II : TC
2
= FC
2
+ VC
2
x Q
At break-even point:
FC
1
+ (VC
1
x Q) = FC
2
+ (VC
2
x Q)

(VC
1
x Q) (VC
2
x Q) = FC
2
FC
1

Q x (VC
1
VC
2
) = FC
2
FC
1

Q = (FC
2
FC
1
)/(VC
1
VC
2
)
Example 2 continued: bowsaw or chainsaw to
cut Christmas trees
Bowsaw
Fixed cost is $5.00
Variable cost is $0.40 per
Chainsaw
Fixed cost is $305
Variable cost is $0.10 per tree
Solution
Q
(break-even)
= ($305 - $5)/($0.40 - $0.10)
= 300/.30 = 1,000 trees


Revenue and Cost as
Function of a Single Input
Marginal Revenue Product
Increase in revenue per unit increase in one
input
= MR / (X
t+1
X
t

)
Marginal Factor Cost
Increase in cost per unit increase in one input
=MC / (X
t+1
X
t

)
Go to Spreadsheet



Example 3: Optimal planting density
No. Trees per A @
5 years
Yield in cords @
rotation
Total Revenue
@$24/cord
300 21.3 511
400 23.4 562
500 25.2 605
600 26.7 641
700 28.0 672
800 29.1 698
900 30.1 722
Example 3: Continued
Fixed costs per acre:
Land . . . . . . . $300
Site prep . . . . 100
Annual . . . . 60
Set-up . . . . . 5
Total . . . . 465
Variable costs per 100
seedlings
Seedlings . . . . $ 5
Planting . . . . 20
Total . . . . 25
TC = 465 + 25 x (# trees per A/100)
Go to Spreadsheet