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An Economic Model for Break-even Analysis

Conference Paper · June 2011

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 An Economic Model for Break-even Analysis

M. B. Ndaliman1,*, U. Y. Suleiman

Mechanical Engineering Department

Federal University of Technology
P. M. B. 65, Minna
Nigeria
1
Currently a PhD candidate in
Department of Manufacturing and Materials Engineering
International Islamic University Malaysia

*corresponding author: mbndaliman@yahoo.com

Abstract:
The break–even theory is based on the fact that there is a minimum production level at which a
venture neither make profit nor loss. This level is called the break–even point (BEP). The total
cost of operations is equal to the total revenue earned at this point. The total cost is made up of
fixed and variable costs. In this paper the fixed cost component is expressed in terms of the
equivalent uniform annual cost (EUAC). The model equations developed were used in a case study
to investigate the various components of fixed cost, and also to generate the trends of total costs,
from which different BEP values were obtained by varying some variables. Results of analysis
indicate that BEP has direct relationship with interest rates and inverse relationship with salvage
values.

Keywords: investments [1]. The outcome of this

Fixed Cost, Variable Cost, Break-even
Point, Interest Rate, Revenue, Equivalent
Uniform Annual Cost.
1. Introduction
Investible funds are limited, and as
such individual entrepreneurs and
government need information on whether the
returns on their investments would be
something tangible or not. A number of tools
are available for seeking such information.
One of such tool is the use of Cost Benefit
Analysis (CBA). This is a method by which
yield or benefits from investments are
estimated by using economic analysis
techniques. Such techniques include the use
of rate of return or present worth of the
analysis helps in the management of human
resources and determines whether the
resources should in the first instance be
channeled to the intended investment or not.
Another tool is the use of Break-even
Analysis (BEA), which is defined as a
method of assessing the effect of changes in
production output on costs, revenue, and
profits [2]. This analysis differs from CBA,
because it determines the viability of an
investment, while BEA finds the production
level at which the venture can earn profit.
The normal aim of the analysis is to
determine the break-even point (BEP). This
point is the level of production volume at
which the total revenue equals the total
expenses [3]. Therefore the industrial
establishment makes no profit and suffers no  There is no income other than from
loss at this production level. Degtiareva [4] operations.
also stated that break-even point shows the 2.2 Formulations
minimum revenue for the enterprise to make Based on the assumptions made
a profit (that is where revenue is equal to above, the break-even quantity could be
expenditures). In determining the BEP, the obtained depending on the model used. In
investor needs to consider at least three this paper, one-product model is considered
variables. These are the total fixed costs, the (Fig. 1). The total cost of producing a
selling price per unit and the variable cost product can be given by:
per unit. This analysis is an important tool
that allows for comparative studies between
TC = F + v Q (1)
costs, revenues and profits [5].
Some benefits of break–even analysis
Where TC = total production/operations cost
include its application in determining the
F = fixed cost for the production period
profit levels and also in conducting cost
Q = quantity produced
reduction impact analysis [6]. It also
v = variable cost per unit sold
enhances decision making process when
The total revenue is:
used in combination with other tools such as
Break-even Default Ratios and Degree of
TR = p Q (2)
Operating Leverage [7, 8].
The main objective of this paper is to
Where TR = total revenue
conduct an economic analysis of break-even
p = price per unit sold
theory, using the technique of evaluating
projects alternatives in conjunction with the TR
fixed costs. A review of the theory is carried
out and the economic parameter (the C/R vQ
uniform annual cost) is introduced into the
model. The model is used to conduct
analysis on the effects of changes in the
fixed cost variable on the BEP. F

2. Theory and Models Formulations

The basic components of break-even QBE Q
are total cost, total revenue and variable cost.
These are shown on Figure 1. Figure 1: One – product

2.1 Assumptions At the break-even point, the total revenue is

The theory is formulated based on equal to the total cost. Thus:
the following assumptions [9]
TR = TC
 The cost function is linear.
 The revenue function is linear.
Thus: p Q = F + v Q
 All products produced are sold at the
same price per unit. QBE = F / (p –v) (3)
 Fixed costs are independent of
production.
QBE is the quantity of production at the
break-even point.
2.3 The use of EUAC in break–even analysis
It has been stated [2] that all the
fixed costs can be expressed as annual costs.
This is why the fixed cost components of
these models can now be expressed in terms
of their equivalent uniform annual cost
(EUAC) by introducing the economic analysis
technique. In this technique all current and
future cash flows of the item that constituted
fixed costs are converted to their EUACs
using the given rate of return.
Consider a break-even analysis of an
investment whose fixed cost is assumed to
be the cost associated with only machine
investment. Then, if the rate of return on
investment is i%, and the annual machine
maintenance cost is m, then, the fixed cost
can be obtained by [10]:
EUAC = P (A/P, i%, N)–S (A/F, i%. N) +m (4)
Where P – the first cost of the machine
S–Salvage/scrap value of the machine
i – Rate of return on the investment
N – Estimated life of the machine
A/P – capital recovery factor
A/F – sinking fund factor
m – Annual cost of maintenance
The factors A/P and A/F are obtainable from
the compound interest tables in any
engineering economy textbook or data book.
Equation (4) can be substituted in the
equations (1) and (3) for F to generate the
expressions for the total cost and the break-
even production quantity respectively for the
model as:
TC = EUAC + v Q (5)
QBE = EUAC / (p – v) (6)
3. Application, Analysis and Discussions
3.1 Application
Consider the following case for the
illustration of the use of the model. A
cassava processing plant is planned to be
established. Estimates of cost data after
feasibility study revealed the initial cost of
establishing it to be $15,000 with an
estimated service life of 8 years after which
it may be resold for $3,000. The plant can
process 30.0kg of cassava per hour. The
annual operating cost including maintenance
is estimated to $2,000. The labor to run the
machine is $8.00/hr. The investor proposed
to charge $06.50 for each kg of cassava
processed and maintains a rate of return
criterion of 18% on his investment. The
break-even and other important variables are
examined in the following paragraphs.
Equation (6) can be used together the factors
A/P and A/F obtained from the interest
tables to give QBE as 880kg. At this
production level ($5,720.00), the investment
would be able to reach equilibrium between
expenses and income, ceteris Paribas. Thus,
the minimum level of cassava processing to
be done per year in order to break–even is
880kg.
3.2 Analysis and Discussions
The model equations (2) and (5)
were used to generate both total revenue and
total cost curves respectively. By varying the
three variables in equation (5), their effects
on break-even point were studied. The
variables are: the interest rate, the
scrap/salvage value, and the annual
operating cost of the machine. The interest
rates were also varied to study the effects on
the dynamics of the BEP. The effect of non
inclusion of the annual operating cost among
the fixed costs was also studied. The results
of these studies are presented in figures 2-5.
Figure 2 shows that the total fixed
cost increases with increase in the interest
rates and vice versa. This is illustrated by the
increase experienced in BEP from about
$4,225 at the interest rate of 8% to about
10000 Variable
$6,825 at the interest rate of 25%. From the Revenue line
Sv =zero
these curves, the break-even point reduces Sv =3,000
8000 Sv =10,000
from the quantity of about 1,050kg to 880kg

Cost/ Revenue (USD)

when the interest rate was reduced from 25%
6000
to 8%. The equivalent revenue earned from
the investment in that range increased by
about $1, 105. This generally implies that 4000

the BEP reduces with reduction in the

interest rate. Thus, more earnings accrue to 2000

the investor, if he can negotiate reduction in

the interest rates that he pays. 0

0 200 400 600 800 1000 1200 1400 1600

Processed Quantity (kg)
Figure 3. Effect of salvage value on BEP at the interest rate of 18%
12000 Variable
Revenue line
Tc at i=8%
10000 Tc at i=18%
Tc at i=25%
Figure 4 showed that the effect of
removal of the annual operating cost is
Cost/Revenue (USD)

8000
6000
4000
2000
0
0 500 1000
Processed Quantity (kg)
Figure 2. Effect of interest rate on BEP
It can be observed from figure 3 that
salvage value of a plant has inverse
relationship with the fixed cost in break-
even analysis. The zero value gave the
highest fixed cost. This is in agreement with
the fact that a machine that could not
generate any scrap value is simply incurring
reduction in the BEP. The BEP is found to
be lowest at about 600kg ($3,900) with the
absent of the operating cost. It increases to
1,400kg at the cost $5,000. Lowest level of
BEP enhances the revenue accruing to the
investment. However, this can only be for
theoretical purposes. In reality, it is not be
1500 2000
possible to operate a plant without running
cost. But the result is indicating that
operating an investment with a minimal
value of operating cost can enhance the
revenue intake.
10000 Variable
Revenue line
COP = zero
8000
COP=3000
COP=5000
Cost/ Revenue (USD)

additional cost to investment, because even 6000

removing it from the plant attracts cost.

4000
Similarly, the salvage value is observed to
have inverse relationship with the BEP. The
2000
highest value of BEP is about 940kg and it
occurred when the salvage is equal to zero. 0 COP = annual cost of operations and maintenance

0 200 400 600 800 1000 1200 1400 1600

Processed Quantity (kg)

Figure 4. Effect of operating and maintenance costs on BEP at i = 18%

 Figure 5 presents the combined effect
of annual operating costs and salvage values
on the BEP at the same interest rate. The
operating cost has more significant influence
on the BEP Than the salvage value. It can be
seen from the figure that large increase in
salvage value only led to little reduction in
BEP. This is not the case with the operating
cost. Finally, caution should be taken while
using the equations because the ‘linearity’
assumptions in both cost and revenue
function may not hold in the real
manufacturing situation [11].
14000
12000
10000
Cost/Revenue (USD)
8000
6000
4000
2000
0 [7] P. Kotter, Marketing Decision Making: A
0 500
Processed Quantity (kg)
Figure 5. Combined effects of operating cost and Sv on BEPat i=18%
4. Conclusions
A break-even analysis model having
some economic variable in it total fixed cost
is developed. It allows the investor to use
these variables in the fixed cost component
of the total cost to generate a number of
alternatives, from which the best one can be
chosen. The analytical technique can be used
to evaluation of potential prices, the impact
of price changes and costs on profitability.
It has also been shown in the analysis
that there is a direct relationship between
BEP and interest rate, and also an inverse
relationship exists between the salvage
values and BEP. It is hoped that correct use
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of this model could assist the investor in
taking the right decision.
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