Operation Strategy

MGMT 707 OPERATIONS MANAGEMENT

BREAKEVEN ANALYSIS Hand Out

Break Even Analysis examines the relationship between fixed costs, variable costs, revenue and volume. What you are attempting to do is to estimate the costs, income and profit or loss under various operation conditions. This is a very useful tool for analyzing multiple options presented to the firm.

Costs: The firm has to have an excellent accounting system to capture and properly categorize all of its costs.

1 Fixed Costs, those costs that do not vary with changes in volume. An example: you plan to open a retail store in a large mall. Your monthly

rent is $3,000. It doesn’t make any difference if you haven’t open your store yet and are outfitting the interior, the rent remains the same. The rent in February is the same as the rent in December.

2 Variable Costs, those costs that vary directly with volume. In your store if you sell 10 dresses at a cost from your supplier of $100 per dress, your costs for the month of February will be $1,000. But if you sold 100 dresses in December, your cost for the dresses will be $10,000. Directly related to your volume.

3 Total Costs, the sum of the two above.

Revenue: The same accounting system must be able to tell you what your revenue is for the time period. So let’s look at that same little black dress. You sell that dress for $250 each no matter what month. So your revenue for February is $2,500 and for December it is $25,000.

The chart on the following table is a graphic representation of Costs and Revenue.

The breakeven point is shown on the last chart.

Break Even Analysis

In Chart Form

Fixed Costs

Variable Costs

Total Costs

$’s

COSTS

REVENUE

revenue

Total costs

$’s

$’s

quantity

quantity

quantity

Breakeven

Point

Now we introduce the Break Even Point: That is the quantity point where your total costs at that quantity is equal to your total revenue for that same quantity.

But this section is about Math Models. So you don’t have to take out pencil and graph paper to do a breakeven analysis. This can be solved algebraically. So let’s do that.

The formula is: Total Fixed Costs = Break Even Point

(Revenue – Variable Costs) per unit

To help you understand let’s just take the denominator [(Revenue – Variable Costs) per unit]. This is called Contribution to Overhead (Total Fixed Costs). What it states simply is that if your revenue per unit is higher than your cost per unit, at some quantity down the line you will make a profit..

Our retail store selling little black dresses: $3,000 = $3,000 = 20 dresses

($250 - $100) $150

So at 20 dresses, the store’s revenue just matches the store’s costs. We break even. Less than 20 we lose money, more than 20 we make money.

Now another example:

You and several friends in order to finance your graduate school education remembered back to your undergraduate days when push carts would appear at 10:00 PM 5 nights a week, Sunday to Thursday, outside of the library and in the two main dormitory courtyards selling Subway sandwiches to the hungry students. You all live off campus but right near the university. And, that service is not offered!! TADA. So you decide to take a good hard look at this.

You would need to rent 3 push carts at the cost of $100 per week. The costs for the bread is $0.50 per sub, the meat is $0.75 per sub, the cheese is $0.45 per sub and the other materials are $0.30 per sub. Looking at the labor component, you could hire students to work at $6.00 per hour and each student could assembly 12 subs per hour. Prices for subs in the surrounding community go for $5.00 per sub. How many subs do you need to sell to breakeven?

Costs 1st: Fixed costs is $300 per week, Variable costs are $0.50 + $0.75 + $0.45 + $0.30 + $0.50 = $2.50 per sub.

Revenue is $5.00 per sub.

So $300 = $300 = 120 subs.

($5.00 - $2.50) $2.50