FAIZ Chapter 8 Breakeven Sensitivity Payback

Slides to accompany Blank and Tarquin 2014, McGraw-Hill Education
Basics of Engineering Economy, 2nd ed. 8-1 All rights reserved

Chapter 8 Breakeven, Payback
PURPOSES TOPICS
! Breakeven value for
Determine a single project
parameters value to ! Breakeven between two
breakeven or payback alternatives
! Payback period for i = 0%
for one or more and i > 0%.
alternatives
2014, McGraw-Hill Education

8-4 All rights reserved
Sec 8.1 Breakeven for Single Project
DEFINITION
Breakeven point is the value of a parameter or decision
variable that makes two relations equal
Breakeven is point of indifference between two projects
Breakeven analysis can be performed considering time
value of money (i > 0%) or without it (i = 0%)
Example breakeven points

! Sales volume necessary to just cover costs
! Price of gas to consumers to just recover drilling,
processing and delivery costs
! Interest rate such that two alternatives cash flows are
equivalent

Two relations equated may be
PWA = PWB or Revenue = Cost
DIFFERENT REVENUE CURVES

COST ELEMENTS
Fixed costs (FC) - Costs incurred regardless
of volume level to stay in business
Examples are:
Building costs - Minimum labor costs
Insurance - Utilities
Capital recovery of equipment
Variable costs (VC) Costs that vary with level

of activity
Examples are: Costs can
Materials costs - Labor costs be
Advertisement - Warranty linear or
Legal costs - Subcontractor costs nonlinear
Sample cost curves for TC = FC + VC
Q = quantity in units
Linear FC and VC Linear FC; VC with

decreasing unit cost

Profit = R - TC
Breakeven at P = 0
R = TC
R = FC + VC
rQ = FC + vQ
Solve for Q to obtain
breakeven point

8 - 10 All rights reserved
Linear Breakeven Analysis Variables and Equations
Linear variable cost: VC = vQ
where v = unit cost, $/unit
Q = quantity, units
Breakeven quantity or point: Q = QBE
Linear revenue: R = rQ
where r = unit revenue, $/unit
Profit when Q > QBE: P = R TC

= rQ (FC + vQ)
Example 8.1:
Nicholea Water LLC dispenses water via vending

machines. Fixed cost per site is $900, each gallon
costs 18 to purify, sells for 30.
- Determine monthly sales volume for breakeven

Sec 8.1 Breakeven Quantity - Example
Water vending machine: FC = $900 per month per site
r = 30 per gallon v = 18 per gallon
Must sell 7,500 gallons per month per site to breakeven

Selling more means a profit is realized
What if the variable cost per unit is reduced through

improved efficiency methods? (see graph on next slide)

Sec 8.1 Breakeven Quantity
As v decreases,
VC = vQ has a
lower slope
Therefore, TC line
has a lower slope
Breakeven point
decreases
Result: Larger profit
for same amount of
revenue

Sec 8.1 Example - Breakeven Quantity
Assume v is lowered from 18 to 15 per gallon
Determine profit at sales of Q = 8,000 gallons/site
QBE = FC/(r-v) Profit = (r-v)Q FC

= 900/(0.30-v) = (0.30-v)8,000 - 900
v, /gallon
0.18 0.15
QBE 7,500 6,000
Profit $60 $300
Q=8,000
Big increase in profit for reduced variable cost
Additional considerations
" Breakeven on a per unit basis:
#Has the same QBE formula
#Average cost per unit is Cu
Cu = FC/Q + v
" Nonlinear R and/or TC relations:

# May have more than 1 breakeven points and there
may be a profit range
# For 2 breakeven points, maximum profit occurs
where separation between R and TC curves is largest

For PW, AW and FW relations when a (one) parameter
estimate is not reliable or known
Given P, F, A, i, n
If all these parameters above are reliably estimated

except one, the unknown parameter can be
calculated or approximated as a breakeven value
To determine it, set PW, FW, or AW equivalency

relation = 0 and solve for the unknown parameter
This approach was used to find ROR (Sec 6.2); the i*

value is a breakeven value
Example:
A professional musician pays $20,000 for a musical

instrument that has 10% salvage value after 5 years.
His costs are $100 per day, and he charges $300 per
day for an appearance.
Find the number of gigs he must perform in a year to
breakeven.

Sec 8.1 - Example-Breakeven Using AW
P = $-20,000 S = 10% of P = $2,000 n = 5 years
r = $300 per event FC = $-100 per event X=?
Find X, number of events per year to breakeven at i = 5%
Solution: Set AW relation = 0 and solve for X
0 = -20,000(A/P,5%,5) + 2,000(A/F,5%,5) 100X + 300X

200X = 4257.46
X = 21.3 events per year
A total of 22 events per year will recover

investment and costs plus slightly more
than a 5% rate of return
Sec 8.2 - Breakeven Between 2 Alternatives
$ Breakeven point is one of indifference between
alternatives
$ Involves finding value of parameter common to the
two relations
$ Can use:
# PW or AW relation at i%, or
# TC relations without time value of money
considered
Solution
Set relations equal and
solve for parameter value

Sec 8.2 - Breakeven Between 2 Alternatives
Selection guideline
Compare the common
parameter expected
level to its breakeven
quantity
! If expected level is <
breakeven, select higher
variable cost (larger
slope on TC line)
(Alternative 1 in graph)
! If expected level is >
breakeven, select lower
variable cost (smaller
slope on TC line)
(Alternative 2 in graph)
Example:
Read Example 8.2 page 214

Sec 8.2-Two Alternative Breakeven-Example 1
Alternative A M
P, $ -23,000 -8,000
S, $ 4,000 0
Life, years 10 5
M&O, $/year -3,500 -1,500
Labor rate $/hr 24 12
People 1 3
Output, tons/hr 8 6
cont
Find breakeven in tons per year (x) to justify
the higher initial cost alternative (A) at i = 10%

Solution approach:
1. Determine VC expression for both A and M using
the common variable x = tons per year
2. Set up AW relations for both alternatives
3. Equate AW relations and solve for x
4. Determine when A or M is selected
A: variable cost expression
M: variable cost expression

8 - 27 cont All rights reserved
A: AW relation
M: AW relation
Equate AWA = AWM and solve for x

-6,992 3x = -3,610 - 6x
x = 1127 tons per year cont

Select smaller variable

cost if tonnage
exceeds 1127 per year
A has smaller variable
cost (3x)
Conclusion: Choose A
if more than 1127
tons per year
Spreadsheet plot of AW
curves shows this
graphically
Buy alternative: 60 per unit
Make alternative A B
P, $ -18,000 -12,000
S, $ 2,000 - 500
Life, years 6 4
AOC, $/year -6,000 -5,000
Overhaul, $ -3,000 each 3 years
Labor rate $/hr 12.50
People 4
Output, units/8-hr 1000 cont
Select make or buy at 125,000 units/year and MARR = 15%

VC AND AW FOR MAKE ALTERNATIVE
Breakeven: x = number of units per year
Variable cost relation:
AWA + AWB VC = -18,000(A/P,15%,6)+2000(A/F,15%,6)

-6000 -3000(P/F,15%,3)(A/P,15%,6)
-12,000(A/P,15%,4)-500(A/F,15%,4)-5000
-0.4x
cont
Equate AW relations for buy and make; solve for x
-0.60x = AWA+ AWB - VC
-0.20x = -20,352
x = 101,762 units per year
At level of 125,000 > 101,762 breakeven

quantity
Select lower variable cost alternative (0.4x and 0.6x)
Select to make inhouse

Sec 8.5 Payback (Payout) Period
Purpose: Determine time (in years, usually) to
recover the first cost or initial investment, P
Payback period is termed np
There are some important cautions to observe

when using this technique
Discussed throughout slides
Two types of payback analysis

# i = 0% no return expected; recover P only
# i > 0% recover P plus return of i%
(also called discounted payback)

Sec 8.5 Discounted Payback Period
! At i% > 0, find np such that annual net cash flow (NCF)
estimates just offset P
where NCF = cash outflows cash inflows
! If NCF forms a uniform series, find np using

Sec 8.5 No-return Payback Analysis
! Determines np when i = 0%; no return expected
! If NCF forms a uniform series, np is simply
! Remember the cautions on using payback

Example 8.7 page 224
J&J Health allocated $18 million to develop a new
treatment product.
Results expected to impact cashflow 6 years from now,

at an average level of $6 million per year.
- Determine pay back periods for both no-return and

at i=10%.

Sec 8.5 Example: No-return Payback
A = $6M
0 1 2 3 4 5 6 7 8 np
P = $18M x
Find payback using PW at 0% (no return)

0 = -18M +6M(x)
x=3
np = 5 + 3 = 8 years

Sec 8.5 Example: Discounted Payback
A = $6M
0 1 2 3 4 5 6 7 8
np
x
P = $18M
Find payback using PW at 10% return

0 = -18M +6M(P/A,10%,x)(P/F,10%,5)
x = 6.9
np = 5 + 6.9 = 12 years (approx)
Requiring a 10% return increases payback
by 50% from 8 to 12 years 2014, McGraw-Hill Education

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What are the different types of costs considered in breakeven analysis?

What are the different types of costs considered in breakeven analysis?

What are the steps to calculate breakeven quantity?

What are the steps to calculate breakeven quantity?

Slides to accompany Blank and Tarquin 2014, McGraw-Hill Education

Basics of Engineering Economy, 2nd ed. 8-1 All rights reserved

2014, McGraw-Hill Education

Example breakeven points

2014, McGraw-Hill Education

2014, McGraw-Hill Education

Variable costs (VC) Costs that vary with level

Linear FC and VC Linear FC; VC with

2014, McGraw-Hill Education

2014, McGraw-Hill Education

Profit when Q > QBE: P = R TC

Nicholea Water LLC dispenses water via vending

- Determine monthly sales volume for breakeven

2014, McGraw-Hill Education

Must sell 7,500 gallons per month per site to breakeven

What if the variable cost per unit is reduced through

2014, McGraw-Hill Education

2014, McGraw-Hill Education

QBE = FC/(r-v) Profit = (r-v)Q FC

" Nonlinear R and/or TC relations:

2014, McGraw-Hill Education

If all these parameters above are reliably estimated

To determine it, set PW, FW, or AW equivalency

This approach was used to find ROR (Sec 6.2); the i*

A professional musician pays $20,000 for a musical

2014, McGraw-Hill Education

Solution: Set AW relation = 0 and solve for X

0 = -20,000(A/P,5%,5) + 2,000(A/F,5%,5) 100X + 300X

A total of 22 events per year will recover

2014, McGraw-Hill Education

Read Example 8.2 page 214

2014, McGraw-Hill Education

2014, McGraw-Hill Education

A: variable cost expression

M: variable cost expression

2014, McGraw-Hill Education

Equate AWA = AWM and solve for x

2014, McGraw-Hill Education

Select smaller variable

Select make or buy at 125,000 units/year and MARR = 15%

Variable cost relation:

AWA + AWB VC = -18,000(A/P,15%,6)+2000(A/F,15%,6)

At level of 125,000 > 101,762 breakeven

Select to make inhouse

2014, McGraw-Hill Education

There are some important cautions to observe

Two types of payback analysis

2014, McGraw-Hill Education

where NCF = cash outflows cash inflows

! If NCF forms a uniform series, find np using

2014, McGraw-Hill Education

! If NCF forms a uniform series, np is simply

! Remember the cautions on using payback

2014, McGraw-Hill Education

Results expected to impact cashflow 6 years from now,